The Tactical and Strategic Asset Allocation of Pension Funds - Term Paper Example

The Tactical and Strategic Asset Allocation of Pension Funds Introduction Asset allocation is not a new buzz word in investment market. The use of the word dates back to the period Circa 1200 B.C - 500 A.D. (Gibson 2000, p.1). But, the word diversification is more often used in place of the traditional concept of asset allocation. It has been a practice among investors that 'avoid putting all eggs in one basket' since the time investment became a serious one. Asset allocation is one of the crucial steps in the process of portfolio building. Institutions having the resources to do so always prefer to seek the professional guidance in this matter, considering its significance and complexity. The process of asset allocation may take place afresh for a new investor or through a review for an existing investor. The review of the pattern of allocation may take place on a continuous basis or periodically. The most important is the determination of the assets, liabilities and assess the net worth of investor that is available for investment. If the goal of the investor is to maximize the assets, the goal should be determined in terms of the assets required to be accumulated by the end of the investment period. This report seeks to brief asset allocation procedure and the strategies and tactics to be taken care of by an investor of pension fund to maintain a balance between risk and return. Pension Funds and its Return objectives The origin of the employee benefit funds can be traced to the late 1800s; but it is their tremendous growth in the last 25 years that has established them as one of the most influential institutional investors in the United States of America. Pension funds dominate the investment scenario in the United States, United Kingdom, Japan and Canada. Almost 90 percent f the pension funds in Japan, the UK and Canada are mid-sized and large private and public sector employee funds. The asset allocation structure for pension funds can differ for both a country and a type of plan. The return from any investment is a function of the ability to take risk and the realization of market expectations. The economic model of defined pension plan is useful in interpreting the questions regarding investment decisions for pension assets. If defined benefit plans are looked at as an act of pension debt-servicing financial institutions, pension asset should be managed in the context of the nature of pension plan balance sheets. The riskiness of the pension fund cannot be judged by comparing with other pension plans or in terms of the absolute values of the pension liabilities, but are based on the nature of the plan liabilities, and in the context of the cash flow and the balance sheet characteristics of the employer liable to pension claims. The objectives set here for the fund is long term return and capital appreciation at the end of maturity. This needs to be done carefully by fund managers and the fund should be allocated in such a manner that majority of the fund should be invested in equity of blue chips so that regular return can be expected and capital appreciation is also possible. However, there may be uncertainties with regard to the return from equity and to protect the investor from such a risk, a sizeable portion should be kept in bonds. The following two approaches will clearly discuss the manner in which the fund is allocated to various securities with different time frames: Strategic Asset Allocation (SAA) The strategic asset allocation process is also sometimes termed as 'policy allocation analysis. This process is carried out at regular time gap, say, once in every three years. Generally the portfolio consists of bonds and stocks with stock invested in 0, 10, 20 100 percent. This process uses Monte Carlo simulation to find out the outcome each asset mix. For the present pension fund, it is in terms of the surplus likely to be achieved year after years. The fund is allocated in such a manner that 80% of the fund is allocated to equity and 20% to debt. It is presumed that asset expected return, risk and correlation remain constant throughout the simulation process. Capital market parameters such as market return are assumed to be constant during the period of analysis (planning horizon). Similarly, the risk tolerance of the investor is also assumed to remain constant during this period. The various stges in the asset allocation process include: 1. Forecasting Capital market conditions 2. Determination of expected return, risks and correlations 3. Deciding upon the risk tolerance of the investor 4. Deciding the asset mix in conformity to the expectations Tactical Asset Allocation (TAA) The performance of the tactical asset allocation is more of a routine activity performed as a part of continuing asset management. It seeks to take advantage of the inefficiencies in the different classes of securities. Here, the expected return on the stock is based on the relationship between the present value of stock market and the intrinsic value of the stock. It is also seen that the expected return tend to fall when process rise and value change by a little difference. In fact, the changes in asset expected returns, risks and correlations will be there even in the most efficient markets though, the tactical asset allocation sometimes is based on the assumption that the market overreact to the available information. This approach of asset allocation considers that the individual's risk tolerance is unaffected by changes in his circumstances. Here, the expected return on the stock is based upon the relationship between the present value of the stock market and the intrinsic value of the stock. It is also possible that the expected return tend to fail when prices rise and value changes by a little difference. In fact, the changes in the asset expected return, risk and correlation will be there even in the most efficient market though, the TAA is sometimes based on the assumption that the market overreact to the available information. However, this approach does not take into account the investor's risk tolerance. Most asset allocation analysis assumes both the present and future market conditions. A careful examination of asset allocation in line with the investment objectives assumes great importance and that is the ultimate objective of investment, long term or short term. Among the various approaches commonly used, popular approach, 100 minus age approach, financial objectives method, risk tolerance method are the popular. Conclusion The main objective of any investment policy is to maximize the returns based on the risk tolerance power of the investor. The investment policy also depends on other constraints like tax, legal complications, and liquidity etc. that are to be pre-ascertained by the investor. The investment goals, constraints and expectations differ from an individual investor to institutional investor. Asset allocation is an essential strategy to attain all the above objectives especially in the context of big funds like pension plans. The systematic asset allocation depends on three assuptions regardless of the type of plan and investor. These include the market provide explicit information about the available returns; the relative expected returns reflect consensus; and expected returns provide clues to actual return. Therefore, any approach is found useful only when all the conditions are satisfied. References Darst David M., 2006, Mastering the Art of Asset Allocation: Comprehensive Approaches to Managing Risk and Optimizing Returns, Edition: illustrated, McGraw-Hill Professional, 2006, 530. Darst David H., 2008, The Art of Asset Allocation: Principles and Investment Strategies for Any Market, Edition: 2, illustrated, annotated, McGraw-Hill Professional, 400. Davison Phoebe, 2001, 'Understanding Benchmarks', Morningstar Research and Company, Viewed March 2, 2009 from Frush Scott P., 2006, Understanding Asset Allocation, Edition: illustrated, McGraw-Hill Professional, 204. Gibson C. Roger, 2000, Asset Allocation: Balancing Financial Risk, ebrary, Inc, Edition: 3, illustrated, McGraw-Hill Professional, 317. Maginn, John L. , Donald L. Tuttle, Jerald E. Pinto, Dennis W. and McLeavey, 2007, Managing Investment Portfolios: A Dynamic Process, Edition: 3, illustrated, revised, John Wiley and Sons, 932. Pension Fund Asset Allocations You Can Use, 2008, 'The Dividend Guy', Viewed March 2, 2009 from, Susan Mangiero, 2008, Pension Report Card - Process, Not Point in Time Numbers, Pension Risk Matters, Viewed March 2, 2009 from http://www.pensionriskmatters.com/articles/asset-allocation/ Read More