Optimi sing a ba lanced  portf olio  While profit cycles play an obvious  role on asset class pricing and returns,  secular inflationary cycles have a much  more profound impact on the real values  of all asset classes. As the pension  manager’s objective is to immunize assets  against inflation, any discussion on  the direction or move into a new secular  inflation regime would not be complete  unless risk/return metrics were analyzed.  However, using the last 20 years  of data as a guide to the future would  be flawed and would open the pension  scheme up to the risk of missing their  stated CPI+ target. For nearly 30 years,  asset class returns have been attractive  from a reward and a risk perspective. 

As previously mentioned, under  deflation investors sought refuge in  the guaranteed income from defensive  assets. Conversely, under rising inflation,  long dated government bonds  noticeably lagged equities. From a risk  budgeting perspective, deflation favours  bonds, rising inflation favours equities.  All this becomes meaningful when  CIOs attempt to build their diversified  portfolios.

Although today many plans  include a more diverse asset class configuration,  real capital asset pricing will  still have a significant impact on how  asset classes perform in the medium  to long term, and will therefore play  a significant role on how a diversified  portfolio is configured. Although the  expected return inputs may be more in  line with the current economic environment,  if the risk metrics are not commensurate  with the new inflationary  regime envisaged, the GIGO (garbage  in – garbage out) rule will inevitably  impact final returns. 

The jury is still out as to the direction  the economy is headed. We’ve  gone from systemic risk to fears of an  economic recession. The month of  October 2008 was one of the worst  on record, and it is therefore difficult  to find any asset manager who is not  claiming that their asset class is oversold.  Although these tactical oversold  readings may be true, how much to  allocate within the diversified fund  configuration will depend on the inputs  utilised within the portfolio optimization  process. Beware of GIGO.