News from Cass Business School

New research outlines benefits of diversification for LGPS

Diversified portfolios can help LGPS maintain lower risk levels

Wednesday, 15 December, 2010

Local government pension schemes (LGPS) should consider diversifying their investment portfolios and reduce their reliance on domestic equities, to help mitigate the medium to long term risks on their investments, according to a new report from Cass’s Centre for Asset Management Research.

Multi-asset class investing and the UK’s Local Government Pensions Scheme, examines the potential benefits of multi-asset class portfolios and looks at traditional equity and bond asset allocations used by pensions schemes versus a broader asset mix, focusing on alternatives, to show how more diversified portfolios can help LGPS maintain lower risk levels and be able to match their liabilities.

The report, co-authored by Chair of Asset Management at Cass, Professor Andrew Clare, and sponsored by J.P. Morgan, argues that the LGPS are exactly the sort of scheme that could implement a more diversified approach to asset allocation. It applies the basic approach of the Yale University endowment fund widely recognised as being a large alternatives asset allocator to test how a diversified approach could work and illustrates the possible benefits.

The authors agree that a weighting of almost 80% in alternatives can be prohibitive for LGPS who need more liquidity, but suggests that Yale’s notably low exposure to domestic US equities (7.5%) and fixed income (4.0%) and high allocation to alternatives* offers better diversification and better returns over the medium to long term due to dramatic reduction in risks such as stock market volatility and correlation of assets.

The report also models the impacts of the Yale asset allocation for LGPS which reveals impressive results. Rather than being faced with additional contributions over a lengthy period, a scheme could potentially reach full funding by 2022 six years earlier than if using an equity and bond allocation. More importantly the modelling shortened the percentile bands, so by 2040, for example, on 95% of all occasions a LGPS is more than fully funded.

Professor Andrew Clare said: Hopefully this paper will help to strengthen the argument for a more diversified investment approach. Although we appreciate that not every scheme would suit such replication, the paper demonstrates how vulnerable those solely dependant on traditional asset classes with no diversification are - especially if equity markets continue their sideways progress of the past 11 years. Pursuing a policy that aims to maximise diversification can help reduce the volatility of asset holdings over the medium to long term and leave schemes much better placed to capitalise on future opportunities in alternative assets.

* Yale University endowment fund invests almost a quarter of the portfolio is allocated to absolute return strategies i.e. hedge funds. A further 25% is allocated to venture capital and leveraged buyout private equity vehicles, while a significant 32% is dedicated to real assets, such as real estate, oil, gas and timberland.

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