In this instalment, we look at how pension schemes can achieve more effective asset allocation by adopting a barbell investing approach

The construction of effective balanced portfolios can be a key component of successful asset allocation from a risk perspective for pension schemes. In order to achieve this objective, many trustees are reviewing their allocations with an increased focus on risk levels and the dynamic between active and passive fund assets.

As pension schemes seek to maximise risk adjusted investment returns against a difficult global economic backdrop, managing portfolio risk and efficient portfolio construction is becoming more important.

Risk Budgeting

The changing nature in how some trustees are viewing asset allocation decisions is exemplified by a trend among pension schemes to adopt ‘risk budgeting’. This involves targeting the highest returns across the portfolio for given quantities of risk. Risk budgeting has led increasing numbers of pension schemes to separate their investment decisions relating to passive and active strategies.

Pension schemes employ a range of index investments to build a well diversified portfolio of market returns that conserves as much of the risk budget as possible. The rest of the available risk is used to target active returns in asset classes that offer greater opportunities for outperformance.

Portfolio diversification has been the predominant focus among institutional investors in recent years. More recently, greater attention has been paid to measuring how successful managers are at turning their skill into investment performance. Far from being an esoteric issue, this mindset has led pension fund trustees to conclude that they should adopt more concentrated active strategies comprising fewer, higher conviction positions.

The same approach can be applied to manager selection; rather than investing with a large number of diversifying managers, a smaller number of ‘high-conviction’ funds are held alongside a balancing allocation to index tracking, or low risk, lower cost funds.

Barbell Investing

So-called barbell investing strategies are among approaches that are likely to appeal to trustees that have adopted risk budgeting in the construction of portfolios. Barbell investing can take many different forms, but typically comprises a high alpha strategy that carries a higher level of risk, balanced with a low risk strategy that tends to be broadly diversified and low cost.

Coincidentally, there has been a trend in the institutional marketplace to seeking market returns (known as beta) in many developed markets, especially equities, together with growth in specialist high alpha mandates in areas such as emerging markets, smaller companies and hedge funds.

Barbell investing focuses trustees’ minds on risk and the allocation of manager fees between passive and active funds. This analysis of various risks in a pension fund’s portfolio may highlight that the active risk does act as a diversifier, especially where passive investments dominate. Trustees are increasingly examining how their risk budget is allocated between active and passive strategies and how to extract the greatest level of return for the fees associated with the strategy.

The barbell concept in action can be seen as clients shift from seeing their portfolios in terms of ‘assets’ to ‘exposures’. Under this approach, the exposure to mainstream equities or government bonds can be gained through derivatives. This means less capital is committed to gain market exposure, which frees up capital for narrower, high-conviction strategies. As a result, the full beta exposure is captured with the addition of high-conviction ideas in an efficient and flexible manner.

Applying the barbell concept when constructing portfolios could result in many barbell investments being created that span all asset classes and investment types in the pension fund. The fund could be viewed as a series of these balancing positions. For instance, trustees could create equity, fixed income and geographic barbells:

• Equity – delineate between passive and high-conviction equities
• Fixed income – match bonds and some higher return debt investments
• Geographic – balance developed and emerging market equities

Liability Driven Investment

Trustees’ evolving attitude to portfolio risk can be illustrated via the emergence of liability driven investment (LDI) strategies. LDI establishes an explicit link between a defined benefit pension scheme’s assets and liabilities and uses this as a basis for defining and measuring investment risk. The strategy generally forces trustees to measure investment returns against scheme liabilities rather than a more general comparison to a benchmark index or against other pension schemes.

A barbell approach can be incorporated in LDI fairly simply. Ensuring sufficient diversification in equity portfolios is a focus in LDI strategies. For instance, core equity holdings can be complemented with unconstrained or high-conviction investments. If trustees take the decision that their pension scheme can afford to carry equity risk versus scheme liabilities, then it is logical that they will want to make that risk work as hard as possible. It’s this train of thought that leads investors to assess the potential of high conviction equity strategies as part of their asset allocation.

Optimising Risk Management

Barbell investing can help trustees cut through some of the complexities and noise that can arise during the portfolio building process. The approach is also likely to require a high level of expertise and governance to be effective, such as monitoring asset allocations to avoid unintended concentrated risky positions arising.

Ultimately, the barbell concept is simply another step in the ongoing search for better ways to visualise and construct more effective portfolios. It can be regarded as a guide to help trustees achieve the best fees/returns trade-off. It may also provide greater focus and accurate monitoring of portfolio constituents for governance-constrained trustees.

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Jargon buster

Barbell investing: So-called barbell strategies can take many different forms. However, all such strategies generally aim to manage risk effectively by balancing risks across the portfolio. The first side of the barbell is typically high alpha, or a strategy that carries a higher level of risk. This is balanced with a low-risk investment, which is usually broadly diversified and lower cost. Effective risk management could result in a series of barbells across a portfolio being employed in all asset class, geographical, sectoral and other areas of perceived risk exposures.

Risk budgeting: An approach which encourages pension fund trustees to achieve the highest investment returns across the portfolio for given quantities of risk.

High-conviction manager: A manager that typically holds fewer stocks and takes larger risks relative to the benchmark than traditional fund managers. This approach can provide managers with more time to focus on the stocks and sectors in which they have most expertise and produce returns that are substantially above the benchmark.

Risk-adjusted returns: Measuring investment performance with reference to both the returns achieved and the level of risk, or volatility, experienced over the same period. Under this approach, a manager with lower returns and risk may outperform a manager with higher returns achieved at the expense of higher risk.

Liability driven investment (LDI): LDI is an investment strategy that establishes an explicit link between a defined benefit pension scheme’s assets and liabilities and uses this as a basis for defining and measuring investment risk.