Creating more volatility

An interesting analysis by Deutsche Bank suggests that public pension systems should have rebalanced a greater sum of plan assets to fixed income following the terrific first quarter performance provided by US equity markets. DB’s analysis found that public pension system’s added only $3.6 billion to fixed income as opposed to >$130 billion had they maintained a static allocation from the previous quarter. Clearly, this hesitancy to rebalance has helped in the short-term as equities continued to advance, but what does this suggest for the future? We’ve been taught that buying low and selling high is a winning strategy. We also know that trying to time markets is also incredibly difficult, which is why asset allocation targets and ranges around those targets have been established as a tried and true discipline.

There are numerous forces at work impacting this lack of an asset allocation action, including an expectation that the US would experience rising interest rates due to escalating inflationary concerns. A move upward in rates would likely lead to a very challenging environment for the typical bond manager. There is also the continuing focus on achieving the return on asset objective (ROA) that drives most asset allocation decisions. However, markets don’t always behave as we might expect. Instead of rising, US interest rates have resumed their march lower, with both the US 10-year Treasury note and US 30-year Treasury bond hitting interest rate levels not seen since early to mid-February.

By continuing to expose these pension systems to greater equity exposure than long-term asset allocation frameworks have determined is appropriate injects more risk into these plans. I don’t know how equities will perform during the next 6-months to a year nor do I have any clue as to where interest rates will go. Unless one is truly confident in one’s ability to forecast these markets, prudence suggests following the course that has been determined through previous analysis. We think that taking equity risk off the table at this time makes sense. Furthermore, we’d suggest using bonds for their cash flows by matching the plan’s liabilities, which provides the plan with a number of benefits that have been discussed in previous posts.

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