Pension schemes are edging away from a decades-long love affair with equities as they seek more diversification, but deciding how to shape the portfolio is still a headache.

Consultants may agree diversification is important for the best risk/return pay-off and that responding to markets in an opportunistic way is vital. However, advice on asset allocation varies widely.

“There is a need to take advantage of a wider range of asset allocation than equities. Real diversification is not just a 5-10 per cent shift away,” says Phil Tindall, a senior investment consultant at Towers Watson, the investment consultants. “We think clients need to be more responsive to market changes, particularly at the extremes,” he adds.

Mr Tindall believes the risk of an equity-focuses strategy is high in an uncertain economic climate, preferring a broad portfolio diversification. Combined with good techniques to manage liability risks, the strategy can improve portfolio efficiency by 20-40 per cent compared to a simple bond/equity mix, according to Towers Watson’s Global Investment Matters publication.

“We have [just] had a lost decade when equities returned close to zero,” says Mr Tindall.

One way to diversify is through different types of credit investments, Mr Tindall maintains. “We think credit has come back to reasonable value now. You can get diversifcation without haveing a complicated portfolio.”

He favours global credit, emerging market debt, asset backed securities and secured loans as a broad credit strategy, depending on market conditions.

Asset allocation also depends on other factors, in addition to markets, including the size and type of a pension scheme and its liabilities, as well as the state of the economy. Traditional schemes that have a large exposure to equities could diversify by switching to alternative investments, in particular funds of hedge funds, says Crispin Lace, senior investment consultant at Mercer.

This chimes with Mercer’s recent survey, showing 700 UK pension schemes continuing to cut their allocation to equities and increasing exposure to alternative investments such as hedge funds, funds of hedge funds, private equity and property.

Schemes reduces their holdings in equities from 54 per cent to 50 per cent, pushing up exposure to alternatives by three percentage points to 9 per cent.

The survey also shows bigger schemes are more adventurous than smaller ones in their allocation to alternatives. Mr Lace believes they usually have better governance, engagement practices and resources to “exploit alternatives directly through a hedge fund, currency fund or global macro fund”, rather than use a fund of hedge funds.

Defined benefit pension funds, in particular, are a “challenging conundrum” says Anne Richards, chief investment officer at Aberdeen Asset Management. The majority of DB schemes are “fully or partially closed, gradually maturing, so the natural inclination is to drift towards fixed income where there is more certainty. But there is also a need for higher returns in the short term,” she says.

However, she believes this push has slowed because so many schemes are “locked into big deficits”.

John Conroy, managing director at P-Solve, a pension fund consultancy, is a keen advocate of what he calls capital rotation, but what to non-experts sounds like market timing. He suggests pension funds should allocate 20-30 per cent of assets to this strategy, which is essentially about responding to market opportunities on a relatively short-term view across a range of asset classes.

Like other consultants he sees a “general acceptance of too much exposure to plain, or naked, equity”. He prefers a split with structured equity such as derivatives, suggesting 25-30 per cent as the recommended allocation, with a strong emerging markets bias.

The pension funds reducing equity exposure are “those most strongly funded”, which “the weaker ones keep higher equities”, according to Colin Robertson, head of asset allocation at Hewitt, a consultancy.

This is because less well funded schemes have more ground to make up to repair their deficits, tending to go higher up the risk/reward spectrum, he maintains.

Mr Robertson says a number of clients are moving away from equities, “thinking about property, hedge funds, currency and infrastructure”. He says careful selection is needed for hedge fund investment where he likes global macro and event-driven funds in addition to long/short funds.

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