The lost world of asset allocation Part 3: Risk Premium Differentials and Liability Frames.

One of the most important determinants of asset allocation is the risk premium on risky investments. 

The lower the risk premium on risky assets the less rationale there is for their inclusion and the longer the time frame of “risky asset risk” that a portfolio will need to manage.  Asset allocation decisions that involve allocating to longer term higher risk growth assets to provide the differential expenditure (income and capital liabilities less portfolio dividend, interest and other income) are about capturing differences in risk premiums.

But this also requires that asset allocation is also framed in terms of units of liabilities as opposed to just units of assets, such that risk management uses size and timing of liabilities as the primary determinant of rebalancing transactions and asset allocation decisions.   The time frame of risk for risky assets is framed likewise in liabilities.

The risk premium differential is intended to provide future capital (from gains) to fund the difference between an appropriate portfolio yield and portfolio withdrawals (income and capital).   How this is managed is key.

While it is clear that the smaller the expected risk premium, the lower the withdrawal requirement and the lower the allocation to risky assets, consumption of capital and hence capital depletion is still the name of the game.   

There are issues here that require consideration and that are of critical importance :

  • Asset allocations are defined in terms of units of liabilities first so that management is focussed on managing liabilities first and asset allocation second.   A liability frame means that actions such as rebalancing consider the need to meet liabilities before then going on to reallocate assets in risk/return space – an overweight position in US equities versus European equities would first consider the overall allocation to lower risk assets for asset liability matching and then the allocation between risky assets.  This may involve an immediate allocation of capital for consumption  as opposed to reinvestment.  
  • Risk premiums, their relative stability and their risk profile, determine the absolute allocation to risky assets, the time frame of the allocation (what is the time frame in which risky asset allocation could impair withdrawal risk management) and hence the withdrawal management strategy.  
  • As the risk premium narrows (or the liability risk increases), the allocation to lower risk assets with greater certainty of return increase and the longer the time frame of risky asset risk.  
  • Historical analysis of risk and return, valuation and the time frame of risk puts the allocation structure into a relevant context at any given stage in the market and economic cycle by providing important liability framed benchmarks for asset allocation.  Point in time valuation analysis (absolute and relative) allows you to quantify risk and return and the likely time frame of risk at any given point in time with reference to structural benchmarks.  Risk premiums and time frames change throughout the market and economic cycle and return assumptions and time frames need to adjust.  
  • While liabilities are fixed, risk premiums and assets prices vary. Portfolio structure needs to be capable of managing the variation and the time frame of the variation so that capital withdrawals are not taken from assets that have fallen appreciably in value.
  • It is important to point out that an asset is not necessarily undervalued just because it has fallen in price, since it may still have sufficient accumulated returns.  Buying at market peaks implies a low to negative risk premium and hence a less pronounced allocation structure.   Buying at market peaks implies a very long time frame for risky asset risk – the risk of having to sell either at a capital loss or an opportunity cost relative to lower risk assets for a significant period of time.   Asset allocation decisions need to be framed in terms of liabilities.
  • Increasing withdrawals in line with increases in returns is dangerous as it places greater reliance on short term increases in price that may not be supported by longer fundamentals.  This risk is managed via the assumptions used to manage withdrawal risk.  As markets rise and returns exceed average expected returns, the future return on assets falls – so rising markets should not necessarily increase the amount an investor can withdraw, unless the excess return is realised immediately.   Raising withdrawals in tandem with prices resets the risk premium calculation and requires much more intense and possibly costly risk management.   
  • Structure of a portfolio in terms of withdrawal strategies: risky asset prices do not go up in a straight line and can take years (sometimes decades) to recover from prior market peaks – it is important that a structure exists to manage this risk. For this to occur you need a portfolio structure whose lower risk asset allocation structure can be used to fund the deficit between income and withdrawals without having to sell risky assets during periods of low asset prices and significant market and economic risk. This type of structure manages both the mathematical sequence of return risk and the more important and more significant, in terms of certainty and duration, cyclical market and economic risks. This type of structure requires involved, integrated asset and liability management.
  • Risk and return assumptions are not fixed: risk increases and return falls as asset valuations rise and the economic market and economic cycle matures; this requires that assumptions used to model the ability of assets to meet financial needs over time should adjust to account for these risks.
  • While over time, from a point in time, the implied riskiness of a risky asset position has tended to decline (i.e. if you only need to withdraw capital every five years the volatility you are exposed to in terms of selling at a price below the initial purchase price falls), the actual equity risk at a point in time does not.   Time diversification of risk only works for liabilities at a distant future horizon and not for point in time financial demands. 

In point of fact a portfolio that would harvest capital gains for consumption should do so while maintaining portfolio integrity.  Low risk asset allocations should not actually be depleted during periods of fair market valuation or rising asset prices.  What should happen is that excess risky asset returns are sold for consumption and/or to maintain the allocation to lower risk assets.  It should be rare, for portfolios defined primarily in liability frames to rebalance assets from low risk to higher risk asset allocations, which is can be the case for portfolios framed only in risk/return space.    

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