Growing Old: Paying for Retirement and Institutional Money Management after the Financial Crisis

Asset Allocation by Institutional Investors after the Recent Financial Crisis

95 Asset Allocation by Institutional Investors after the Recent Financial Crisis 5 Asset allocation is the key to the long-term performance of institutional investors; it has determined more than 90 percent of their performance over several decades.1 For example, if an institutional investor held a diversified portfolio of U.S. stocks from 1991 to 1999, it would have recorded excellent performance regardless of the individual stocks selected. Conversely, that institution would have recorded relatively poor performance from 2000 to 2008 if it held a diversified portfolio of U.S. stocks regardless of the individual stocks selected. By asset allocation, we mean the division of an institution’s capital among a variety of asset classes in accordance with the institution’s long-term policy goals. The asset categories may be fairly broad, such as stocks, bonds, alternative investments, and cash. Alternatively, they may be fairly specific, such as U.S. stocks, non-U.S. stocks, government bonds, corporate bonds, hedge funds, private equity, and real estate. This type of long-term asset allocation should be distinguished from tactical asset allocation. Strategic asset allocation is aimed at fulfilling an institutional investor’s policy goals over a full market cycle lasting at least five to ten years. Tactical asset allocation is an attempt to take advantage of short-term opportunities robert c. pozen betsy palmer natalie shapiro 1. Brinson, Hood, and Beebower (1986); Brinson, Singer, and Beebower (1991). in the market when certain asset categories appear to be out of line with economic fundamentals. Tactical asset allocation may be performed quarterly, monthly, or even daily.2 This chapter examines strategic asset allocations by institutional investors globally after the financial crisis of 2008 to 2009, focusing on changes in asset allocation by corporate and government defined benefit (DB) pension plans, foundations, and university endowments.3 These institutional investors have considerable discretion in setting their asset allocations. By contrast, changes in asset allocations by mutual funds, defined contribution (DC) plans, and brokerage accounts are directed primarily by their retail customers and their advisers. The first part of the chapter delineates the main trends in asset allocation from 2007 to 2009 by institutional investors in various geographic areas—the United States, Europe, Canada, the United Kingdom, Japan, and Asia excluding Japan (hereafter referred to as Asia). The key trends include —decreased allocation to equities (together with a shift from home country to global equities) —increased allocation to fixed income —increased allocation to alternative investments. The second part evaluates these key trends in asset allocation in light of the policy objectives apparently driving them. The shift from domestic to global equities will probably fulfill the objective of more diversification of risk for institutional investors. While the shift from equities in the aggregate to highquality bonds is likely to reduce portfolio volatility from year to year, that shift entails more interest rate risk, especially in the current environment of historically low rates. The sharp rise in institutional allocations to alternative investments does not appear likely to meet the objective of consistently positive returns in all market environments, though alternatives are likely to be less volatile on a year-to-year basis than stocks or possibly bonds. The third part of the chapter analyzes in depth the factors influencing asset allocation decisions by specific types of institutional investors—DB pension plans of S&P 500 companies, DB pension plans of state and local governments, and investment funds of foundations and endowments. Because of limits on data availability, these analyses are confined to institutional investors within the United States. In an effort to “de-risk” their portfolios, corporate DB plans are moving allocations from stocks to bonds. However, as explained above, those plans 96 robert c. pozen, betsy palmer, and natalie shapiro 2. Anson (2004). 3. This chapter sometimes refers to “institutional investors” as “investors.” may be taking on considerable interest rate risk at the wrong point in the cycle. If interest rates rise, the value of their bond portfolios will be reduced, although their projected liabilities also will decrease. By contrast, public pension plans are taking a more aggressive stance by concentrating heavily on international equities and alternative investments. Although that approach can be explained by the large funding deficits faced by many public plans, those plans run a substantial risk of not meeting their ambitious goals for investment returns. Last, endowments and foundations also are poised to expand their already heavy reliance on...