(May 24, 2012) — Corporate pension funds should implement dynamic portfolio strategies in order to meet their challenges, according to research published by the EDHEC-Risk Institute.
Pension risk is not only driven by the funding ratio of the pension fund, but also by the financial strength or weakness of the sponsor company, the paper — produced alongside BNP Paribas Investment Partners — asserts.
One of the key findings of the paper shows that imposing a cap on funding ratios has a positive impact on both pensioners and bondholders, while only having a minor negative effect on equity value. Dynamic asset allocation strategies aim to control sponsor risk by avoiding states of the world where the pension fund is underfunded and the sponsor is unable to make up for the gap, the paper says.
The release by the EDHEC-Risk Institute follows research published by the CFA Institute, which championed dynamic portfolio construction to manage risk. “Portfolio management is moving toward a more flexible approach capable of capturing dynamics in risk and return expectations across an array of asset classes,” the paper written by Peng Wang and Yizhi Ge of Georgetown University and Rodney N. Sullivan of the CFA Institute earlier this year asserted. “The change is being driven, in part, by the observation that risk premiums vary as investors cycle between risk aversion and risk adoration and that the decision to invest—whether to take risk and how much—is the most important investment decision. Certainly, managers should take risks, but only if the returns appear to represent fair compensation.”
The CFA Institute’s paper concluded that the traditional strategic approach of fixed-asset allocation is outmoded, and that therefore, there is much-needed dynamic flexibility to the asset allocation process. When asked how dynamic portfolio construction compares with a risk parity strategy, Sullivan told aiCIO: “While risk parity attempts to equalize risk across assets within a portfolio, a dynamic risk approach aims to adjust risk levels across the entire portfolio in accordance with a market risk forecast. While risk parity has generally the same asset weighting across all market environments in the short-term, our model dynamically adjusts portfolio asset allocations commensurate with the market risk environments.”
Related article: Trustees, CIOs Question Assumptions Behind Risk Parity, Dynamic Asset Allocation