Portfolios with liability demands need to be run along liability tracks with a greater sensitivity towards a) liability risks in terms of benchmark allocations to risky assets and allowed for deviations from those benchmarks and b) cyclical market and economic risks and especially significant structural risks that could materially impact returns on risky assets.
It is more what portfolios do in terms of adjusting allocations given liabilities profiles as risky asset prices inflate, than what portfolios can and cannot do in a risk event when asset price declines have pre-empted any possible move.
I was just reading a recent article in the Financial Analysts Journal “Flight to Quality and Asset Allocation in a Financial Crisis”. While I thought the article addressed some key dynamics of risk event pricing and the reality of adjusting asset allocations in the midst of such price movements, it missed some important issues.
Clearly, the conclusion made, that most investors are not going to be able to make much significant change in a financial crisis, is a moot point. In my Capitalism in Crisis series, in my third report, I dealt with this area, but addressed the market timing, money supply growth, cash and resulting allocation dynamics as opposed to equilibrium pricing and risk premium readjustment. It only takes small changes in preferred portfolio allocations to move markets significantly and this is itself a limitation on the actual transactions that can and need to take place.
The above noted report did emphasise the fact that there is little point in selling after the event, given that expected returns on risky asset classes would have risen to offset much of the risk, and that trying to sell at these lower levels may require a further price adjustment to entice new buyers. But, what I thought the report failed to address was the fact that market prices prior to the crisis had failed to properly price the systemic structural financial and economic risks and it is here that more work needs to be done in terms of portfolio risk management. I do not believe that the crisis was a random event, nor was the prior bear market that started in 2000.
In my 3rd Capitalism in Crisis report I made some comments on the desirability of adjusting portfolio allocations (given liability profiles and the implicit economic relationship between asset allocation and saving and consumption decisions), in response to advanced market and economic cycles, and especially so where significant structural risks are building up.
I feel that if portfolios were more focussed on liability risks and the risks to the ability of assets to meet liabilities, that much of the excess risk we seen during previous cycles could well have been moderated. We see much rebalancing with respect to strategic allocations but we do not have accepted disciplines with respect to rebalancing referenced to liability profiles and risk adjusted returns.