It’s The Objective That Defines the Asset Allocation

I had the great pleasure of attending (and speaking at) Opal’s Emerging Manager conference in NYC for the last couple of days. I always come away having learned much more than I knew before the day started. However, in the last panel of the conference, the moderator, an influential plan sponsor, who I know and really like, asked the members of his panel why pension plans were later to the game investing in hedge funds than E&Fs and HNW individuals.  The panel highlighted a number of potential reasons, but I think that the question was phrased inappropriately.

I would have asked the question are hedge funds more or less appropriate investments for pension plans than either E&F or HNW individuals? My response would have been that the fund’s objective(s) should be what drives asset allocation and individual product exposures. My feeling is that E&F and HNW individuals have annual positive spending policies that dictate more of an absolute return orientation and that pension plans have a relative objective – that being their specific liabilities (benefit promises). Thus, E&Fs have every reason to want and need to produce a consistently positive return, but pension funds need to outperform liability growth, whether that leads to a positive return or not.

By focusing on the return on asset assumption and not liability growth, pension systems have severely underperformed liability growth since 12/31/99 by an astounding 170% (according to Ryan ALM). Of course, this period coincided with two major market declines, but the negative impact of these bear markets would have been mitigated had assets and liabilities been more in lock-step with one another. Focusing exclusively on the ROA has injected significantly more volatility into the asset allocations for pension plans than how they were managed decades ago. I’m afraid that the singular focus on the return objective is setting these plans up for significant underperformance and rapidly escalating contribution costs should we encounter another bear market in the not-too-distant-future.

Investing in hedge funds won’t protect the asset side of the equation from underperforming plan liabilities in such an environment. They might help E&Fs and INW individuals, but then again, they have a very different annual objective.


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