At UK high street bank Abbey, which has recently outsourced some of the largest asset management mandates in history, CIO James Bevan starts every day thinking about whether allocations for his 18m clients are correct. Scottish Mutual, one of Abbey’s life insurance subsidiaries has received much criticism for cuts in mid-term payouts to 50,000 investors.

These investments were previously managed in-house. It is debatable whether you can blame fund managers for these shortfalls. It is more likely the fault of actuarial boffins, who based their short-sighted calculations on healthy late 1990s stockmarket returns.

However, during his review of investment processes governing Abbey’s entire £30bn client assets, Mr Bevan found these life funds need to have a much greater equity exposure. By incorporating asset allocation into the investment process, he has much more information and technology at his disposal than had the back-room boys of old.

A slightly different call has been made by Michael Hughes of Baring Asset Management (BAM), grandaddy of the CIOs. While BAM believes money can still be made from bonds, Mr Hughes has told investors to beware of the “wrong kind of bonds”. Schemes and life companies must re-examine their allocations now, before they begin losing money and are forced to give excuses to investors, similar to the “wrong kind of snow” which once derailed Britain’s creaking transport system and briefly curtailed Eurostar’s cross-channel operations.

The secret, says BAM, will be to look to more, not less active management of bond portfolios, allocating increased tranches to index-linked bonds and emerging debt. Being long of duration and holding credit through the cycle is dismissed at “yesterday’s strategy.”

Bizzarrely, it is inflationary stability which is causing unpredictability in bond markets. Inflation targets of 2 and 3 per cent “are now viewed across the West as core to policy,” says Mr Hughes.

Volatility in bonds markets will result as central banks move rates up and down to maintain these targets. This makes active management of duration much more important.

But is such inter-class diversification enough? No, says Philipp Vorndran, chief asset allocation strategist at Credit Suisse Asset Management’s Zurich head office.

“Institutional investors must increase their awareness of possible asset classes,” says Mr Vorndran. “I am 100 per cent convinced that it is not good enough to look at bonds, equities and some kind of alternatives. They need to broaden their horizon to include commodities.”

He describes his difficulty convincing clients in 1999 to diversify into real estate. “Every client we tried to pitch laughed in our faces. Five years later, real estate is a prominent asset class. Now it’s the same story for commodities.”

Two years ago, CSAM tried to launch an actively managed fund investing in raw materials, but was forbidden to do so by Swiss regulators. “After some negotiation, we were allowed to launch a passive fund,” recalls Mr Vorndran, another former portfolio theory lecturer. “The only asset allocation call we were allowed was the benchmark. Should we choose the more metal-driven CRB or energy-dominated Goldman Sachs Commodity Index? Luckily, we picked the Goldman index, so clients have been extremely happy on performance.”

Colin McLean, founder of SVM Asset Management, a Glaswegian funds guru recently described as “dour but interesting”, is also calling for institutions to allocate assets to natural resources, although he favours indirect investment into European stocks, which trade in the energy-guzzling US.

“Europe is trading on a 14.5 multiple and the US on 23,” says Mr McLean. “BP and Shell trade in the US and are playing on the same themes and economic dynamics, but are much cheaper to own.” He believes BP is significantly under-owned by the majority of institutions, and is generating significant excess cash. In the current market climate, this asset allocation question appears more important than ever.


Yuri Bender, editor-in-chief
yuri.bender@ft.com

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