A dose of wisdom from Ash Williams
Jared Gross: Defining objectives is the first step when building and implementing an asset allocation policy. How did the FSBA team arrive at its return target?
Ash Williams: The first and highest duty of any return objective-setting process is to understand what the liabilities are and when they come due, and to make sure you have the assets on hand to pay them in full and on time. In the real world, this requires asset returns of sufficient magnitude to make good on future obligations.
Annually, FSBA reviewed its liabilities for changes driven by demographics, longevity assumptions or payroll growth, and reconciled those against current asset values and prospective returns based on long-term capital market and inflation assumptions. This gave us a return target that was consistent with both our goals and the market environment.
This was not a purely empirical exercise; it required commonsense judgment as well. For instance, a rising equity risk premium resulting from a fall in interest rates should not simply lead to ramping up equity exposure. Capital market assumptions are incredibly useful for thinking about the future, but they are not a substitute for sound reasoning.
Consistent with our trustees’ risk sensitivity, we also imposed prudent constraints on the process: to avoid undue short-term volatility that could lead to contribution spikes, and to ensure adequate liquidity. A detailed, total fund investment policy statement contemplated all these variables and was adjusted each year.
Gross: The classic 60/40 portfolio, though a bit of a straw man, still serves as a proxy for investors’ exposure to public markets. What have we learned recently about this approach?
Williams: The 60/40 stock-bond model worked really well for most of my career, which perhaps explains why it has become so entrenched. But we must recognize that a key driver of this success was the broad decline in fixed income yields that delivered outsize returns beyond what was contemplated in contemporaneous allocation decision-making.
More recently, however, the extreme decline in bond yields led to concerns about insufficient returns and—critically—a possible lack of risk diversification. If you have diversifiers that aren’t contributing to return objectives, they had better be effective diversifiers! Investors quite rightly began to seek returns and diversification from other sources, including alternatives and the broader “endowment model,” in which alternatives play a key role.
The trade-off with this approach is less liquidity, which imposes other risks and constraints on investors’ behavior. In 2022, we heard a lot about the so-called denominator effect, which is one manifestation of the problem. The drive to hold more illiquid private investments may slow a bit, but not simply as a reaction to liquidity management. As we’ve seen in the most recent Long-Term Capital Market Assumptions, a balanced portfolio now is expected to produce a U.S. dollar return north of 7%, which is very appealing.
Gross: The entry point for public markets is now far more attractive. Should investors consider deviating from their strategic asset allocation to move more money into fixed income, equities or both?
Williams: Yes is the short answer. If an investor sees the prospect of earning returns that satisfy long-term objectives while maintaining a higher degree of transparency and liquidity, and lower execution costs—all of which could be associated with increasing public market exposure—then why not take advantage?
Further, most asset allocation regimes contemplate some flexibility around the timing and magnitude of rebalancing, within bounds (and if they don’t, they should). There’s commonly a range around target allocations at the asset class level. Institutional investors often have relatively limited tactical flexibility, but they should certainly take advantage of the flexibility that they have been given.
I will also suggest that, in a period of significant market volatility, simply rebalancing back to last year’s strategic allocation is likely suboptimal. Being thoughtful about when and where to rebalance may be a source of long-term value. Broadly, stocks and bonds look more attractive than they did a year ago, but a deeper consideration of specific sectors within each market may reveal compelling opportunities.
Gross: After strategic asset allocation comes finding the right managers, setting investment guidelines and alpha targets, and determining fees. Do any markets absolutely require active management? Are any better done in passive vehicles?
Williams: The answer to the first question is yes. The answer to the second question is maybe. And here’s why. One’s consideration of the appropriateness of active management should be guided by a continuum. Very simply, the less efficient markets are, the more likely one is to be rewarded for active management.
The continuum would run from the least transparent, liquid and efficient—think frontier equities or frontier sovereign debt, where active management is nearly mandatory—to the most liquid developed market securities; think U.S. large cap equities, where it is less so.
There’s been a bit of an illusion created, particularly since the global financial crisis, that passive is the way to go. And that is a very naive presumption, which arose during an unprecedented period in which increasing globalization, disinflation and accommodative policy created a rising tide lifting all boats. That tide has now turned.
Globalization arguably has gone into reverse. Disinflation has been replaced with inflation. And policy has moved from supportive too restrictive. That situation makes the broad market gains of the past decade less likely and the passive strategies that thrived on them less effective. Conversely, the greater volatility and dispersion across sectors and securities make active management far more likely to succeed—even in the broadest and most efficient markets.
Gross: Compared with public markets, private markets tend to offer higher returns but less transparency and liquidity. How do you find private market managers you can trust across time?
Williams: An absolute requirement is that the character of the managers with whom you partner is of sterling quality. You simply cannot have people who are unworthy of your trust—particularly when you lack the ability to demand your money back or liquidate your positions.
Second, the terms of the business relationship should represent an appropriate balance of interests across both parties. It’s a partnership, after all. Structure deals that make sense for the manager and the investor; over the long term, I’ve learned that it’s not in my interest to have long-term partners feel like I’ve bullied them down.
The rewards are very real, despite the higher level of complexity and the lower level of transparency.
Gross: Institutional investors often lack the tactical flexibility to respond to dynamic market environments. Is tactical asset allocation a missing piece in many strategies?
Williams: It can be. Reaching a balance between strategic patience and tactical flexibility is an important element of an effective asset allocation. A thoughtful rebalancing program is a starting point but is usually insufficient. Active managers help too, but they may be constrained by their benchmarks and guidelines.
At FSBA, we sought to structure mandates with some managers that were very, very permissive—to take advantage of their breadth, depth and expertise across markets, and so that they could identify transient opportunities and had the latitude to act on them. Some can be characterized as genuine strategic partnerships, and others are simply flexible mandates that cross traditional asset class boundaries.
I can’t think of any that disappointed. It was reassuring to know that when markets were moving rapidly, we had strategies in place that could take advantage.
Gross: Investors have been under pressure from the denominator effect on their strategic allocations—potentially resorting to costly secondary market sales of private assets. What’s your take on this?
Williams: The so-called denominator effect is a confluence of rapidly declining public markets and illiquid alternative assets. For those whose governance structures allow patience and flexibility in returning to their strategic allocation, the impact is manageable. For those who are forced to rebalance in short order, the consequence is a costly and inefficient return to benchmark. This is an object lesson that even the best-intentioned investment policies, if applied too literally and without appropriate flexibility, can lead to bad outcomes.
It is also a reminder of the value of liquidity as a store of opportunity (or optionality, if you will). An ideal situation occurred at FSBA in 2008–10. Initially, our asset allocation was out of whack because of dramatic market movements and a delay in rebalancing while a CIO was being selected. (That CIO turned out to be me.) Once I arrived, we rebalanced the portfolio and were positioned to benefit when the market bottomed in March 2009. We had all the sails up when the wind came back, so to speak, and values began to climb.
We stayed liquid throughout this process, while a number of institutions found themselves overweight private market assets with callable capital commitments they could no longer fund. They became forced sellers in the secondary market, whereas we had the liquidity and the flexibility to step in as a buyer—a golden opportunity that delivered superior returns.
Gross: What investment opportunity is looking attractive to you over the next couple of years?
Williams: The easiest call right now may be the broader core bond sector, which can include opportunistic, income-focused and multi-sector credit strategies. These are offering compelling yields with relatively limited risk—a big shift from the paltry yields and thin spreads of one year ago. Active management in fixed income can enhance returns and reduce risk across time, making broader and more flexible mandates ideal for this uncertain environment.
It may require some fortitude, but if you look around at what’s cheap on a relative basis, ex-U.S. markets look appealing. The strength of the dollar makes this a good time to move capital into offshore markets broadly. I think that parts of Asia, and China in particular, may be good opportunities, given the current entry point.
Closer to home, there should be opportunities within tech, which has been seriously beaten down, as well as within health care. But stock picking requires skill, and it is critical to partner with an experienced and well-resourced manager adept at navigating the equity opportunity set—and not simply chasing the momentum trades.
Finally, the carbon transition is clearly in front of us now. From an investor’s standpoint, this creates enormous disruption, and opportunity, for both existing firms in the public markets and emerging firms in the private markets. A lot of changes will have to take place over time to accomplish even a fraction of what’s been set forth in political and public policy discussions. And there will be opportunities all around that set of changes. I have no doubt about that.