"It's time to plan for the winding road ahead, rather than driving using the rear view mirror," says Cardano's James Balcombe as he discusses a new way of thinking about portfolio construction for pension funds.

Like it or not, we live in an increasingly uncertain world undergoing often fast and sometimes unforeseen economic changes. Given this new environment, many argue that it's time to embrace a new way of thinking about portfolio construction that is better placed to help pension funds navigate this uncertainty and prepare for the unexpected.

As a bit of background, traditionally pension funds have relied heavily on historical returns and volatility data when it comes to deciding on where to invest. This unhealthy reliance has often led to a large and frequently static allocation to equities, because history says that over the (very) long term equities outperform bonds handsomely. What many don't consider is that this large allocation to equities is often effectively a huge and potentially risky bet that the economy will grow healthily. If the economy were to enter a prolonged recession, or even just grow at a much slower rate than in the past, equity returns are likely to disappoint - leaving many pension funds struggling to recover.

Step in a new forward looking scenario-based investment approach that has seen increased interest from the pension fund industry in recent years. Here the aim is to produce both stable and balanced returns, whilst not being overly exposed to any one economic outcome.

Through this investment approach, pension fund trustees would initially investigate and model the expected returns of a range of assets in different economic scenarios, usually with the help of an investment consultant or fiduciary manager. Given the desire for some assets that perform well in each of the most likely scenarios, it is unsurprising that these potential investments can be quite varied. For example, in addition to more traditional investments in equities and bonds, funds that are able to profit from both up and down market moves (absolute return funds, or hedge funds) are often attractive given the flexibility they can bring across different market environments. Some may even consider assets principally designed to perform well in a stressed market or recessionary environment, like equity options strategies or swaptions, and which only lose small amounts in other scenarios.

Once this analysis has been completed, assets can be grouped according to the scenario they perform best in. Capital can then be allocated across these scenario groupings partly taking into account the view of the likelihood of each economic scenario over the next few years. Importantly, the aim is to secure stable portfolio returns with limited downside no matter what economic scenario materialises. This often results in a trade-off between those assets that will perform well in the most likely scenario and the need to pay for protection in potentially adverse scenarios.

Taken together, a scenario-based approach has a real potential to produce good and stable long-term returns. Whilst it's clear the methodology promotes a well-diversified portfolio, it also encourages pro-active adjustments to the investment mix as and when the economic environment is expected to change.

Over the last five years, portfolios that follow this approach have typically outperformed equities, with significantly less volatility.

For pension fund trustees, it's time to plan for the winding road ahead, rather than driving using the rear view mirror.

Written by James Balcombe, client team, Cardano

J.Balcombe@cardano.com