Would you drive as fast as usual on an icy road? Of course not, notes Seth Masters, chief investment officer of blend strategies and defined contribution services and a partner at AllianceBernstein. The same care you take relates to how to adjust investment behavior. “You need a shock absorber to live through bear markets,” he reasons.
AllianceBernstein has spent 40 years in asset allocation and Masters a little over 20 years, yet he contends that research on asset allocation makes it hard to predict markets. How much equity risk can you stomach? A safe rate is 60 to 70 percent equities, classic advice dictates. “Usually a volatility rate of 9 percent a year is acceptable, but in fall 2008, volatility was 20 percent — not what we bargained for.”
Returns that take into consideration downside risk do reasonably well when the markets are good and won’t fall as precipitously. You need certain kinds of guarantees, allocations that offer downside protection, that protect that negative tail risk — which can be associated with a rise in systemic risk and a decline in liquidity.
For AllianceBernstein, the first product offered to reach that objective is a line of variable annuities from Transamerica Asset Management Insurance Co. and recently the firm added Metropolitan Life Insurance Co., too, as sub-advisors for dynamic allocation variable annuities portfolios.
Dynamic asset allocation works to reduce extreme outcomes in portfolios to deliver more consistent returns. “Initially introduced within our own private-client business, dynamic asset allocation is the result of a multi-year firm wide research effort to provide all types of investors with a less volatile investment experience, without sacrificing long-term return potential,” Masters says.
AllianceBernstein’s dynamic asset allocation approach “is the silver lining that comes out of 2008,” Masters notes. The model seeks to de-risk portfolios when investors aren’t adequately compensated for bearing a high-level of volatility in the market, and modestly increases exposure when opportunities outweigh risks. “It’s a sensible idea, a smoother ride during the rough patches in the market, to look at the plan and adjust, so that you won’t lose as much.”
Risk management lessons are continually lost as market players gets lulled into complacency, forgetting that equities are very risky and that investors demand compensation for risk, reminds Francis Kinniry, principal in the investment strategy group at Vanguard. ETFs at Vanguard are used extensively as a portfolio’s core. “Then, we can employ active management to try to outperform indexes,” Kinniry says.
Having a solid core that tracks the market adds a lot of risk control. Institutional investors are employing indexes and ETFs increasingly as their core investments for market return. “You don’t want to have large tracking error — that you’re way off your benchmark or policy portfolio,” Kinniry continues. Investment committees are sensitive to variations around the policy portfolio. There has been incredible focus on what is investment policy to the benchmark: there’s low tolerance for tremendous volatility and thus, larger mandates towards risk controls.
But AllianceBernstein’s Masters is not wildly enthusiastic about ETFs, saying that they’re just a vehicle that trade intraday. “It’s a very old idea, based on basic premises that markets are efficient, and that passive management should be cheaper. Owning a passive portfolio is legitimate, assuming it’s an efficient portfolio.”
Notes Vanguard’s Kinniry: “With equity-centric pension plans, in which equities are 30 percent to 40 percent or more of the portfolio, there’s a lot of volatility right there, and then, adding commodities, real estate investment trusts (REITs), or private equity, can lead to contagion. ETFs can lower risk by allowing investors to buy an entire market in global equities or taxable fixed income or other asset classes.”
