Tactical allocation & default funds

It’s interesting to see so many different approaches to DC defaults out there in the market.

Since pension freedoms, customers typically want to retain greater flexibility through drawdown, with a higher level of risk – at least during the first phase of flexible retirement as they pass through their sixties and early seventies. Younger savers should also be taking a higher level of risk in their pensions.

The question is whether to do this through a straight equity approach or through a more diversified approach. We favour the latter.

We dampen growth-phase volatility in default funds by including a small allocation to asset classes like bonds. When given the choice, few customers opt for unalloyed equity market volatility and the lifestyle journey we offer that’s fully invested in more volatile growth-seeking assets in the early years doesn’t see significant take up from individuals coming to us via financial advisers.

We also see great potential for diversifying within growth-seeking assets by including commercial property and commodities as a compliment to equities.

There are a number of geopolitical scenarios that can play out in a very damaging way for stocks while boosting commodity prices, such as military conflict between the US and Iran. 

Domestic property also offers diversification from more globally-focused equity exposure. Property prices would leap if Brexit were cancelled, for example, but an associated rise in the pound would hamper UK and global equity returns for a sterling-based investor.

Many defaults take a static approach but we have a strong commitment to tactical asset allocation and we have the risk budget within the funds to facilitate it. We use an Investment Clock approach that links market returns to the global business cycle. We aim to shift the asset allocation to avoid the worst impact of market falls while standing ready to take advantage of upside opportunities as they arise. As a result we will on occasion, build up bond holdings and even cash sometimes within the growth phase strategy.

We’re now 10 years into what has become the longest US economic expansion on record. Our Governed Portfolio default fund, launched in January 2009, has benefited from this, delivering growth-phase savers 10.6% a year since then¹.

We don’t think the next recession is imminent and we’re moderately overweight stocks and high yield bonds in our funds.

Within this decade of growth, there have been three clear mini-cycles. 2012 saw fears of a financial crisis relapse and the potential collapse of the Euro; 2015 saw the devaluation of the Chinese currency and fears over Glencore; and in 2018 we had selloffs both in Q1 and at the end of the year on trade war concerns. 

As long as inflation remains low, central banks are likely to ease policy and engineer a new upswing in global growth as they did on previous occasions. This process is already under way with the US Federal Reserve widely expected to start cutting interest rates again and the UK’s special Brexit situation making it an exception.

There may be volatility in the short term in this tug-of-war between stimulus and tariffs, but with Trump wanting to get elected again in 2020, markets look on balance favourable.

1 Royal London data, May 2019

Sterling and the Euro have been trading in a tight range for the last two years, but this could change abruptly once the Brexit outcome becomes clear. Sterling could easily fall 10to 15% in a chaotic No Deal Brexit or rise by a similar amount if Brexit ends up being cancelled after a second referendum. This is an unprecedented level of currency risk for a developed market. 

From a tactical point of view, we’re trying not to take big bets that rely on correctly predicting a highly fluid and uncertain political situation. We prefer to lean on the degree of natural hedge that comes from having both global equities and domestic property in our Governed Portfolios. UK equities source around 70% of their revenues overseas and for global equities the figure’s naturally higher still. A pure equity portfolio would offer little protection from a Brexit outcome taken positively on the foreign exchanges.

Exotic and expensive high yield assets look attractive at first glance, but I’m sceptical of anything delivering north of a 7% yield when the risk free rate from gilts is less than 1%. We’re offered aircraft leasing investments, peer-to-peer lending vehicles and renewable energy infrastructure bonds paying income as high as 10% a year. 

This is great as long as the economy remains on track, but if there’s a recession we could see credit losses slashing the value of these assets and liquidity could dry up completely.

We’re also wary about exchange traded funds (ETFs) promising liquid exposure to an illiquid underlying. Yes they can still be traded, but you can be sure there’ll be a significant discount if markets turn sour.