Alice: I’m not a serpent, I tell you! I’m a -- I’m a --
Pidgeon: Well! what are you? I can see you’re trying to invent something!
Alice: I -- I’m a little girl
Pidgeon: A likely story indeed! I’ve seen a good many little girls in my time, but never one with such a neck as that! No, no! You’re a serpent; and there’s no use denying it. I suppose you’ll be telling me next that you never tasted an egg!
Alice: I have tasted eggs, certainly, but little girls eat eggs quite as much as serpents do, you know.
Pidgeon: I don’t believe it, but if they do, why then they’re a kind of serpent, that’s all I can say.
This was such a new idea to Alice that she was quite silent for a minute or two
Alice’s Adventures in Wonderland, Lewis Carroll
Categorisation helps us make sense of the world. It brings a level of order to the sea of information we swim in. However, with new information, we must re-think those categories or they become meaningless and arbitrary. This appears to be the case for pension fund investment.
It is clear that the investment space for pensions (accessible and ventured) is no longer just Equities and Bonds; Growth and Matching. If I replay back to when I first fell down the pensions rabbit-hole, it seems to have started with the growth of credit assets. First there were corporate bonds, then there were investment grade and junk, now we have asset-backed securities, mezzanine debt, high yield, loans, leases etc.
So what makes an asset “growth” or “matching”?
What is the level of return that earns an asset class the title “growth”? Is it “matching” if it has duration*? Even now with corporate bonds, you would be unable to get a consensus for “growth” or “matching” with a group of 10 pensions people. How are we to make good investment decisions using a system that is inconsistent within its own industry?
Having a category which then bundles everything else together is not helpful either. With regards to “alternatives”, it bears remarkable resemblance to a magical police box of a certain fictional time lord; bigger inside than it appears on the outside, it can take the rider to some fantastic places but the passenger gets lost or left behind with an alarming frequency...
Rethink: what do pension funds need from their assets?
Before we dive into conjuring every shade of classes between matching and growth, perhaps it’s time to rethink what pension funds need from their assets. Even without the last few crises, it is clear that risk, return and relative value is subjective and will fluctuate.
So what then, are attributes that pension funds universally value? After some deliberation, it boils down to 2 things:
Cashflow: Does the asset provide a steady income and is it contractual (i.e. relatively certain)?
Liquidity: Is there an established market for the asset and how easily / quickly can you sell it?
By just taking these two characteristics, we get an alternative categorisation system
Different asset classes can then appear on a pension fund’s radar as follows.
How to improve Governance and Strategic Focus
The list is by no means comprehensive. But by boiling it down to these key components, pension funds can improve their governance and focus strategic asset allocation in the areas most appropriate to them. For example, a mature scheme near full funding will seek assets primarily in the liquid contractual space (top right quadrant). A relatively younger scheme with lower funding but having the luxury of a longer investment horizon, will venture for more illiquid non-contractual assets (bottom left quadrant), in search of higher risk premia.
At the end of the day, this is playing in content i.e. one can chop and change asset classes and call them whatever we like. But it would mean nothing without setting the context. This means agreeing a personalised framework for individual pension funds, set out with clear objectives and constraints such as cashflow requirements and liquidity tolerance (my previous blog on why setting a framework matters here).
As with everything, there is another way and as always, I welcome your thoughts.
*Duration: used in this context in terms of sensitivity to interest rates. Technically, it means this.
Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer.