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Understanding Asset Allocation

Understanding Investments

Investing, whether retail or institutional, starts with a basic portfolio in which assets are divided among different categories of investments. Asset allocation - deciding which investments are chosen and in what proportion - must take into consideration long term goals, such as tolerance for risk and the current and future needs for funds.

When developing an asset mix - the percentage of the fund invested in specific asset categories - a number of factors must be taken into consideration.

Diversification

Given that different asset classes will perform differently depending on the behaviour of the markets, it stands to reason that spreading investments among a variety of asset classes makes sense. Bonds, for example, perform well when interest rates are going down, however generally they tend to provide low, albeit predictable, returns. A portfolio that comprises mainly bonds is not likely to meet the return target of a typical pension plan. The same applies to highly "correlated" portfolios, in which investments may be very different, but behave similarly under certain market conditions. A successful portfolio will maintain an assortment of asset classes in order to take advantage of fluctuating economic climates.

Diversification is also achieved within asset categories by breaking them down into smaller sections. Equities, for example, can be divided into "public" and "private" and be can be further subdivided by region (North American, Global) and size of company (small cap, mid cap). This type of diversification takes advantage of the effect that factors such as geography can have on the performance of a single investment category.

Time Horizon

Paying pensions indefinitely is the ultimate goal of pension plans. It's not enough to achieve investment returns that are adequate for the current needs - a long-term entity like a pension plan relies on strategies that look well into the future. This involves making assumptions about changing demographics, the nature of liabilities, and the behaviour of interest rates. By understanding the type of funding that will be required in the coming years, plans can tailor their asset allocation strategies towards achieving their long-term funding goals.

Risk

It's critical that pension funds remain viable by earning a high enough return on their investments to grow the fund at least as fast as the liabilities grow. Normally the higher the risk the greater the potential rewards, as long as the risk is identified and managed well. Although the term "risk" has a negative connotation, pension plans must take some investment risk in order to achieve the required returns. The successful plan will understand the investment risk inherent in all asset classes, and the interest rate risk that has an impact on the cost of the plan's liabilities.

Rebalancing

Once an appropriate portfolio is established, steps must be taken to maintain the policy asset mix. Over time, due to changes in the markets, some asset classes will grow faster than others, causing the asset mix to deviate from the policy. For example, an allocation to bonds that makes up 40% of the fund could increase to 43% if interest rates fall. Although this may seem like a minor variance, it can represent a significant discrepancy for a pension fund. An unbalanced portfolio does not represent the ideal asset mix initially determined for the plan. Rebalancing is an ongoing process that involves shifting funds from one area of the portfolio to another, in order to restore the original mix.

These are just few of the many components that must be considered when developing and maintaining a pension plan portfolio

October 2008