The global slowdown has exposed the vulnerabilities of traditional asset allocation, according to senior managing director of State Street Global Advisors (SSgA), Shawn Johnson, while sharing the AA implications he believed would be relevant depending on the ‘shape’ of the global economic recovery. “Correlations tend to ‘1’ during a crisis, so the theoretical minimum variance, maximum return portfolio construction doesn’t really help,” Johnson told an SSgA client conference in Sydney last month. Most institutional investors were not able to react quickly because “they are slaves to longterm asset allocation models and committee decisionmaking”, said Johnson, giving the example of one US fund which needed three committee meetings and 45 days to shift managers.

Another vulnerability which has been revealed is a limited understanding about the risks of asset classes beyond volatility measures (such as liquidity, which is generally not modelled). The lack of liquidity has even affected holders of listed securities, Johnson said, because the management of cash collateral associated with their securities lending programs strayed into markets which froze as the crisis took hold. Liquidity constraints going forward are numerous, Johnson said. First, collateral pools may be inactive for some time as they wait for maturities to roll off, and mandates which excluded the use of securities lending were growing in popularity.

Second, cash yields will remain low for a long period – Australia is the first to raise rates, and the $A will keep rising, he said. Johnson said significant pension funding gaps were causing investors to re-evaluate process and asset allocation. According to SSgA analysis, pension plans of S&P 1500 companies were facing a record US$400 billion deficit. “The average funded status of the largest US companies is now only 75 per cent, far short of the required 94 per cent that companies must achieve by next year under the Pension Protection Act,” said Johnson.

In positioning for recovery, funds must manage risk exposure, protect liquidity, and reset asset allocation policy, Johnson said. Investors will also need to form a view on inflation, Johnson said. “Economists are divided on inflationary concerns: shortterm forecasts for the next 12-18 months see a limited risk of inflation in the US and Eurozone. “But, longer term concerns exist given the stimulus packages, making future economic projections difficult.” The most likely result is stag-flation in the US, said Johnson, because of its high imports of cars, oil, and computers. “In a strong economic recovery —“V” shape —the question is how much downside risk do we face in our bond portfolios?” he said, while equities faced a greater threat from a “U” scenario.

Leave a comment