The resources boom has changed the beta of Australian shares in a way that may alarm those with a passive approach to asset allocation. The regional chief executive of Lazard Asset Management, ROB PRUGUE, here puts his value prejudices aside, and calls on investors to at least reconsider where the risks in their portfolios are coming from.
Dear friends and colleagues; It is often said that asset allocation is the single largest factor in delivering a diversified fund’s total return. Most large funds generally have between seven and nine asset classes, while holding between 20 and 30 investment strategies, that in turn tend to hold between 30 per cent and 100 per cent of the underlying securities from the asset class’ benchmark. Too much in the wrong asset class can have a much greater drag on the fund’s total risk/reward than bad stock selection from any one manager. But what if the benchmark in the single largest asset class is dominated by one name? What impact will this one name have on the diversification profile of most balanced funds? In such a case, can stock selection play a bigger role than previously envisaged?
Before we start, it is best to define diversified funds. What separates a ‘balanced’ fund from a ‘growth’ or even a ‘defensive’ diversified fund? The purist will answer from a risk/return trade off point of view whilst the pragmatist will usually answer with an asset allocation mix between shares and bonds. The pragmatist generally defines a balanced fund as 60/40 or 70/30 shares/bonds, whilst the purist defines it through an expected return target of CPI plus 4 per cent, or positive expected returns in six out of seven years. Of the two, however, the pragmatist usually prevails. Rarely are diversified funds actively rebalanced to maintain risk/return objectives as stated above. If they are, it’s usually done through the management of ongoing cashflows.
Take, for example, yesterday’s bifurcation between the ‘old’ and ‘new’ economies. Whatever the thesis driving this bifurcation of yesterday, its impact was felt well beyond most equity portfolios alone. For many North American defined benefit (DB) pension plans, its impact saw plans move into a 30 per cent plus funding surplus at the turn of the century, then back to a 30 per cent deficit by year end 2002. Although the majority of Australia’s pension liability is defined contribution (DC), to quote Keith Ambachtsheer, “At the end of the day, it’s still someone’s balance sheet we’re immunising”. DB and DC differ only in who ultimately immunises this pension liability.