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Improving your 20-20 vision

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For all sorts of obvious economic and political reasons, 2010 has got to be the year of reviewing asset allocation.

After all, no one can seriously deny that events over the past few years have challenged the traditional views on the risk:return characteristics of the various asset classes. I think any pension fund that is certain its current strategy will continue to maximise return with no impact on risk, or continue to minimise risk with no impact on return, is a very lucky fund indeed. Or a master of timing.

But before focusing our attention on determining again in detail which securities, asset classes and sub-classes are optimal for our funds, I think we should just allow ourselves a little free thinking, pause for thought and consider the overriding impact of two rather new phenomena.

The first of these is the irresistible change in the order of the world’s markets and economies. Most of us will have noticed that a substantial number of the world’s emerging markets have not only come through the recent global economic and financial crisis relatively unscathed, but are actually in better shape than before the sub-prime market kicked off the credit crunch.

In truth, the rise of the more established emerging markets such as Brazil, India and China was always predictable, and by 2020 it’s likely that all these markets will feature equally with many of the more developed markets. But what is also very interesting is that many other markets, particularly in Latin America, have shown themselves to be more robust than some of the major economies of the West.

Similarly, few will not have noticed the huge public spending deficits in developed countries. But the private sector has also been busy borrowing and we have huge levels of corporate debt - particularly in the United States and Europe - as another hangover from the free-spending era of the easy credit of the past decade.

In the US something like $560bn above the capital market’s normal capacity for new issuance will be needed between 2012 and 2015; in Europe the crunch comes a little later, with $255bn needed between 2013 and 2016.

What does this mean? Well, we need to think globally. We are learning the hard way that while international securities are going to continue to be an essential part of any portfolio, the exposure to country risk is going to be much more material in the risk:return calculation than ever before.

And with globalisation that is also going to be a much more complex and difficult calculation than before.

But we also need to think locally. The second new thing is this: politicians have been quiet about the details of public sector pension reform but change is clearly on the way. No doubt all will become clear once the independent commission has reported. But something important is already in place in the local government pension scheme - cost sharing.

This has perhaps been largely unnoticed so far but if pension capping - limiting the amount the employer has to contribute, which has already been widely canvassed - also comes into play then this will certainly concentrate everyone’s attention.

Cost sharing was intended to deal with the impact of benefit changes, or even perhaps longevity. But, if there is an absolute cap, that means investment performance will now have an impact not on the employer but on the workforce, resulting in changes to their contribution levels and/or benefits.

Imagine trying to explain to the workforce that they have to pay more because the investment strategy didn’t quite work out. It will be difficult enough to explain away underperformance as a result of stock picking, but at least that can be attributed to the managers. Asset allocation, though, is very much a trustee decision.

The pressure to move towards a more conservative portfolio with capital preservation could be irresistible. Which could be fine - so long as inflation doesn’t rear its ugly head. If it does, well, then at least that is something that can be explained. In other words, keeping it simple and explicable might be the most important thing.

Finally, 20:20 vision is usually seen as good. But in investment strategy terms, it’s only average, and therefore won’t be good enough. What we really need now is something better than that.

Chris Bilsland is chamberlain of the City of London

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