“From our perspective there are two ways to make money in markets, you can hire a smart manager to make market-timing calls, or you can bet on markets. Most people are more comfortable with the strategic asset allocation approach, and the most important focus is a better diversified portfolio.” To achieve this, he says, means more focus on risk allocation and not capital in setting the asset allocation of portfolios. “The capital allocation by super funds is dominated by equities, but portfolios don’t earn returns on the money invested but on the risk we take. About 85 per cent of the risk is in equities,” he says. To eliminate the equity dominance in asset allocation, he says investors need to look at the drivers of return, and the relationships between different asset classes changes with different economic conditions. For example if growth is a driver, then equities and commodities will behave differently to nominal bonds and inflationlinked bonds.
Similarly, if inflation is the driver, then inflation-linked bonds and commodities will behave differently to equities and nominal bonds. “A typical portfolio now is dominated by equities so the portfolio will be dominated by economic environments [in which] equities do well or badly Funds need to position their portfolios to do well for all environments.” He says a more balanced portfolio would allocate [according to risk] 24 per cent to equities, 33 per cent to nominal bonds and 22 per cent to inflation-linked bonds, 13 per cent to commodities, 4 per cent to emerging market debt spreads, and 4 per cent to corporate spreads. Equities have dominated pension fund allocations because investors have been chasing returns, he says.