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By adopting a contrarian approach to
rebalancing which takes account of both assets and liabilities, super funds could
enhance long-term returns and reduce the volatility within their portfolios, new
research reveals. Rebalancing Revisited, a paper by Syd Bone, former chief executive of VFMC, and
Andrew Goddard, an ex- Russell investment veteran, advocates super funds
rebalance to a preset target, for example an investment return target of CPI +5
per cent per annum.

Presenting the paper to the 2009 Biennial Convention of the
Institute of Actuaries
of Australia, held in Sydney late April, Bone
said the optimal investment outcome is obtained when a preset, reasonably
achievable target is established and then periodic rebalancing is carried out
with reference to that target. The target might be an investment return, or the
ratio of assets versus liabilities. “Rebalancing has traditionally been done
between asset classes,” Bone said.

“A lot of super funds are finding that difficult
and allowing their strategic asset allocations to drift.” Bone said target
rebalancing was “contrarian in nature”, requiring funds to underweight risky
assets such as equities during bull runs and overweight risky assets during
bear markets. “This approach would be calling now for funds to start putting
risk back on the table,” he said. “This can be difficult for trustees.”

Bone
and Goddard “backtested” their rebalancing model and compared the results with
what would have been achieved had the assets been invested in a conventionally
rebalanced portfolio with 60 per cent of the assets in Australian equities and
40 per cent in Australian bonds. The liability was taken as known to be $100 at
December 31, 2008, and liabilities at previous dates were determined from both
an actuarial and accounting standpoint.

The paper showed that a super fund which
followed the proposed contrarian investment strategy and rebalanced relative to
the actuarial liability for the 10- year period to the end of 2008 would have
earned 8.5 per cent per annum compound and incurred less volatility in its
asset to liability ratio than a super fund which adopted the traditional rebalancing
method. Assuming a portfolio invested in a 60/40 mix of Australian equities and
bonds, the super fund that followed the traditional rebalancing approach would have
returned 7.9 per cent over the same period.

According to Goddard, the
contrarian approach also outperformed the traditional approach over 20 years
(from December 31, 1988) and over 70 years (from December 31, 1938). Bone and
Goddard admit there are practical difficulties in maintaining a contrarian
target rebalancing approach, which “flies in the face of normal human behaviour”,
which is to increase risk when ahead and reduce risk when behind.

“For this
reason, any real world application of this kind of contrarian approach is most
likely to succeed if it is ‘automated’, following a pre-agreed set of rules
which do not envisage external review or override,” the paper noted. “It will
also almost certainly be necessary to limit the extent to which the automatic
implementation is permitted to diverge from the ‘base case’ strategic asset
allocation.”

 

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