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Why the Size of the Fixed Income Allocation Doesn’t Tell You How Risky the Portfolio Is

Willis Towers Watson makes the case for an objectives-based approach focusing on specific risks like equity beta and interest rates.

Investors often use the percentage of capital allocated to fixed income to define how risky a portfolio is — but that’s a faulty way to measure risk, according to a new paper by John Delaney, Willis Towers Watson’s senior investments director. 

Historically, corporate pension plan investors and other asset owners have associated less fixed income with higher risk. For instance, Delaney wrote that a portfolio composed of 60 percent equity and 40 percent bonds is often considered riskier than one that’s majority bonds.

“There’s been an emphasis on the idea that my fixed income has to track my liability exactly, and there’s flaws in that logic,” Delaney told Institutional Investor. “If I’ve got, for example, 40 percent in fixed income, and that tracks the liability exactly, that doesn’t really matter if the other 60 percent completely loses money. I’ve failed my overall objective.” 

Delaney argued that using fixed income as a key indicator of risk is narrow in scope. In the paper, he pushes for investors to worry about the performance of their entire asset pools and structure their portfolios around objectives specific to their institutions, all while placing capital allocation on the back burner. 

“Institutional investors have worked with these simple fixed-income guides, which, we think, lead to narrow thinking and potentially undesirable outcomes,” Delaney said. “We want to expand the way they think about it.” 

Instead of looking solely at the percentage of a portfolio allocated to fixed income, Delaney wants investors to determine risk by asking themselves three questions: “What actual return objective do I need to reach versus my liability? How much equity sensitivity can we really tolerate? And, how much interest rate risk are we willing to hedge?”

This approach includes moving the emphasis away from fixed income and toward the specific risks that plague institutional investors, including equity beta and interest rate hedge ratios.

In the paper, Delaney tested three portfolios of varying bond/equity compositions (50/50, 60/40, and 70/30) across various risk measures. All three portfolios had relatively similar fluctuations in performance, as measured in equity beta and tracking error relative to liabilities, over a three-year period. No one portfolio significantly outperformed another, supporting the idea that less fixed income does not necessarily mean more risk.

While investors may lose the benefit of simplicity that comes with using fixed income as a risk metric, Delaney argued that an objectives-based approach has two main advantages: Investors can assert control over risks that pose concerns to them, and investment strategies and portfolios can evolve alongside market conditions.

He suggested for example, that investors could create a portfolio that is 80 percent diversified-return-seeking strategies and 20 percent liability hedging.

“That generates higher potential returns than a 60 percent equity/40 percent investment-grade fixed-income portfolio, while being less ‘risky’ based on the risks you need to manage,” he wrote in the report. “And don’t let the potential shift from 40 percent to 20 percent hedging assets discourage you; just make sure you’re asking and answering the right question.” 

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