Solutions

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Low yields, volatile markets, extreme events and pressing demographics are all driving attention towards solutions-based investment.  Pension funds are under pressure, and there is a need to be able to find asset returns in a difficult environment where even sovereign risk is actually risky. Opportunities to succeed will lean on those asset managers who are able to develop more flexible and dynamic asset allocation in their models. 

The word ‘solutions’ has become so overused, that the fund industry at last is taking a different determination of what it is trying to mean. It means, in the main, ‘outcomes’ and an investment approach focused more on risk and absolute returns.  Low yields, volatile markets, extreme events and pressing demographics are all driving attention towards solutions-based investment.

Since the global financial crisis in 2008, there has been a growth in demand for strategies and investments that protect against significant negative returns.  Meanwhile, yields on once considered safe government bonds such as gilts and T-bills have fallen so low that there is no obvious benefit from these once-traditional safe havens.  Retail investors are bewildered. They are looking for some level of certainty in their investing, and increasingly, education is coming to the fore to try to explain volatile markets and uneven returns to investors.

With uncertainty introduced through central bank experiments such as quantitative easing, investors are challenging the merits of traditional investing techniques, such as balanced funds for pensions.   Assets during the crisis showed themselves to be more correlated than would historically be expected, which is leading institutional and retail investors to seek out ways to meet their investment outcomes and limit their risk exposure at the same time in the event of a repetition of the crisis.

The main problems that are leading to solutions orientation as a business are low yields, volatile markets, longevity of funds, particularly pension funds that are under pressure, and the need to be able to find asset returns in an environment where even sovereign risk is actually risky. So, opportunities to succeed will lean on those asset managers who are able to develop more flexible and dynamic asset allocation in their models.

This challenges traditional balanced managers who had a concept of a 60/40 split and that the results following that allocation would look after themselves.  Nowadays risk needs to be targeted in a far more calculating way and dynamic asset allocation is needed, a skill acquired that can look at all dimensions of the asset universe and using the tools be able to try to achieve it. This is a brave new world for asset managers and not all are comfortable with it.

BNY Mellon and Cass Business School explore in a white paper called “Outcome oriented investing for retirement – from the DC scheme member’s perspective” that lifestyling needs to move away from mechanical asset allocation.  Their paper examines a ‘dynamic’ investment strategy that is outcome driven, targeting the generation of an income in retirement that will offer a minimum acceptable replacement ratio, relative to the income earned during employment.

“Tail risk” is the aspect that reminds people that, actually, there is a danger related to investing overall. It became a hot topic after Nassim Taleb’s ‘Black Swan’ in 2007 and is one which has seen that investors cause the most problems with their holdings and that the causes of fat-tailed outcomes can be managed in certain ways, all of which have pros and cons. Tail risk exists, but, equally, to deny it exists means that you won’t avoid the risk.  To manage it, one has to enumerate the different possible outcomes. These outcomes may include adopting a lower beta strategy, remaining less in the market than one would have done traditionally, or some form of passive or active hedging policy to try to reduce the volatility that is coming through on an unexpected basis.

Market risk has been shown in many of the so-called hedge funds, insofar as they actually had more embedded beta than perhaps their investors originally thought. Tail risk remains a problem for many, and banks are coming up with different option strategies as potential ways of reducing that tail risk in portfolios, but, as said previously, this comes at a cost.

In a paper explaining the use of diversified growth funds by pension funds, authors from Clearpath Analysis explain that diversified growth funds do not remove risk, but offer a different type of risk.  They say: “it should be stressed that investors do not remove risk when moving from multi-asset to diversified growth to absolute return funds; they simply change the type for risk relied on from market risk to manager/active risk.”

Overall, the business of Solutions will continue to grow as the fresh approach to asset and indeed risk management emerges. 80% of managers now place “solutions” among their top three growth priorities according to McKinsey.  Investors now have shorter time horizons and changing attitudes and expectations towards risk and return. In the West, the traditional pensions industry is looking for solutions; older corporate defined benefit schemes are looking to out-risk and solve liability problems and the newer defined contribution schemes with personalised risk are recognising that lifestyling needs to move away from mechanical asset allocation of old.

 

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