investing in a volatile world

Investing in a Volatile WorldAugust 2020

Investing in a Volatile World 2

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

Table of Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Review Resources and Governance Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Rebalance with Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Look Toward Market Opportunities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

1 . Opportunity Allocations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2 . Medium-Term Views . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

3 . Traditional Active Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Reassess Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Prepare for the Next Period of Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12



The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Investing in a Volatile World 2

Investors have had to manage risk, returns, and liquidity during many volatile times, including the oil crisis in the 1970s, the “tech wreck” of the early 2000s, the 9/11 terrorist attacks, and the global financial crisis . Through it all, many institutional investors have risen to the challenge and planned for the turbulent times we find ourselves in today . While the past helps us prepare, we also need to ascertain which new approaches are appropriate .

As institutional investors in North America look out over the next several years, they must reassess their portfolios and governance structures. These reassessments help investors evaluate whether they are prepared for an evolving environment where an organization can face enterprise-level threats and rapidly changing markets simultaneously.

This paper provides a framework for institutional investors to respond to volatility consistently and thoughtfully in ways that should help improve returns and oversight while reducing risks and costs.

The financial markets have tested institutional investors mightily over the past five decades .



Review Resources and Governance StructureInstitutional investors should first review their governance structure – the processes for decision making – to understand how they can respond when there are changes in the market or what they require from the portfolio .

Evaluate the roles of advisers, staff, and the investment committee to find out where authority lies for making decisions. Is the investment process sufficiently nimble, while also having appropriate risk controls? Does the investment team have knowledge and authority to react to a changing market? Is the team able to raise liquidity and take advantage of price dislocations during a crisis? While the answers to these questions should have been established before the market crisis, they ultimately drive what an investor can do in the crisis and indicate how likely they are to be successful.




Rebalance with DisciplineAn organization should look to its investment policy statement (IPS) for guidance on long-term asset allocation and rebalancing .

The IPS typically includes target allocations and allowable ranges, providing a framework for the investor’s tolerance for long-term risks (target allocations) and tactical positioning (the width of the allowable ranges). Investment policies should have been created with thought and care to guide fiduciaries through future market conditions, so investors should use them to navigate challenging times.

Rebalancing helps investors stay focused on long-term policy. Generally, an investment policy statement should have guidance as to whether to rebalance to target, rebalance within range only, and provide details under what circumstances rebalancing might be suspended altogether. The most fundamental part of rebalancing is to manage risks by avoiding being too far from the target asset allocation.

In down markets, organizations should use rebalancing to move back into return-seeking assets. Rebalancing takes advantage of market dislocations with its buy-low-sell-high mechanism. Rebalancing strategies have historically outperformed strategies that don’t rebalance.

To demonstrate the impact of rebalancing, we tested two portfolios, starting at a split of 60/40 between equity and fixed income over multiple historical bear markets that have lasted more than one year. Portfolio A rebalances every month to its target allocation while Portfolio B drifts with the markets. Over all bear market cycles tested, the disciplined Portfolio A has outperformed a non-rebalanced Portfolio B, as shown in the table on the following page.

Rebalancing helps investors stay focused

on long-term policy .



Source: S&P. Hypothetical returns are not necessarily indicative of future results and there can be no assurances that one will achieve comparable results. The hypothetical performance calculations are shown for illustrative purposes only, cannot be invested in and do not represent an actual client account. Hypothetical performance results have certain inherent limitations and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees and other costs.

Institutional investors can apply tilts to rebalancing within the existing asset allocation categories in investment policies. Most investment policy statements have both target allocations and ranges, which allow tilts to be used in a risk-controlled way.

Investors can transact explicitly to create the tilts, done within the bands of the investment policy. Often investors use tilts more to determine how they rebalance and allocate cash flows. The tilts affect whether to rebalance above or below target, where contributions should go, and what to sell when funding cash outflows.

Investors also can use rebalancing transactions to improve the manager lineup. For example, if an investor has several fixed income managers and wants to reduce the number, the investors could consider selling assets disproportionately from one manager. However, this strategy should be thoughtfully evaluated to determine whether it introduces undesirable style biases by selling only from that manager.

A reasonable approach to balance transaction costs and unintended risks of rebalancing is to target midway between the target allocation and policy bound. For example, if the target allocation to equity is 50%, and the minimum of the policy range is 44%, then make transactions to get to 47% equity.

Rebalancing Helped in Bear Markets

Market Peak (High)

Market Trough (Low)

Recovery (Back to Previous High)

Starting Value at the Peak

Rebalanced Portfolio at the End of the Cycle

Un-Rebalanced Portfolio at the End of the Cycle

August 1929 June 1932 December 1944 $1,000,000 $1,613,582 $1,376,983

November 1968 May 1970 March 1972 $1,000,000 $1,207,810 $1,199,369

January 1973 October 1974 July 1980 $1,000,000 $1,508,309 $1,474,515

November 1980 September 1981 November 1982 $1,000,000 $1,300,311 $1,296,684

March 2000 October 2002 May 2007 $1,000,000 $1,401,198 $1,379,608

October 2007 March 2009 March 2013 $1,000,000 $1,270,614 $1,245,958

PORTFOLIO A PORTFOLIO B


Look Toward Market Opportunities

There are three broad ways investors can use active management to pursue market opportunities, which can be done separately or together . The governance structure of institutional investors will influence how successfully they can capitalize on the opportunities during volatile markets . Each requires different skills, resources, and nimbleness .

Opportunity Allocations

Medium-TermViews

Traditional ActiveManagement




1. Opportunity Allocations

An Opportunity Allocation is not an investment in and of itself; instead, it is part of an investor’s governance structure that helps facilitate the execution of great ideas in the portfolio .

It builds flexibility into the investment policy statement to enable investors to make investments that may not fit within a traditional asset category. It is designed as a maximum allocation as opposed to a target. It’s usually designed with a 0% target allocation and a maximum of 10%.1 Adding one to the investment policy could allow greater flexibility to pursue interesting opportunities.

For more than a decade, Aon has helped many investors use Opportunity Allocations. These allocations have typically become more attractive during periods of dislocation when some niche strategies become desirable. An Opportunity Allocation provides flexibility to access such opportunities by reducing constraints of formal asset allocation.

Many investment opportunities emerge from market dislocations in down markets. Here are some examples of investments in Opportunity Allocations currently considered by Aon clients:

• Opportunistic credit strategies have become compelling after the market crash of Q1 2020, as governments and central banks provided price support for some assets, but others remain dislocated at prices below what we view as fair value. Some less liquid, more complex parts of the credit markets offer unusually good value.

• Insurance-linked securities can generate attractive returns that are generally uncorrelated with the financial market, especially when events that deplete insurance company reserves can increase demand for reinsurance (e.g., unusually high insurance claims in the prior year’s hurricane season).

• Opportunistic real estate includes strategies that invest in both public and private real estate debt and equity assets that are dislocated from fundamentals and/or exhibiting distress. The current market environment can be advantageous for this style of real estate investment. These are typically longer-term investments with a horizon of 8-10 years.

1 Pension plans on de-risking glide paths often structure the maximum allocation as 15% of the return-seeking assets so it scales down as the plan de-risks.

Opportunity Allocations have typically become more attractive during

periods of dislocation when some niche strategies

become desirable .



2. Medium-Term Views2

Most institutional investors can apply tilts within the existing asset allocation categories in investment policies, as investment policy statements typically have both target allocations and ranges . The ranges allow tilts to be conducted in a risk-controlled way .

This approach to portfolio management is supported by extensive evidence, including the research earning the 2013 Nobel Prize in Economics, which was awarded for showing empirical evidence about how market valuations affect – and don’t affect – the prospects for returns.3 In summarizing that research, the Royal Swedish Academy of Sciences said, “There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years.”4

That is, there is academic research that markets are partially predictable, while there is also validity to conventional wisdom that it is difficult to predict the direction of markets. It is impossible to correctly predict what markets will do, but there appears to be strong evidence that markets in some environments are more conducive to favorable expected returns. For example, when Treasury bond yields are very low, the expected returns for Treasuries is not very high.

Aon’s Global Asset Allocation team has a process for developing asset allocation views, which can be used to tilt portfolios. The process focuses on three areas: valuation (e.g., price/earnings ratios), fundamentals (e.g., economic environment), and market awareness (e.g., technical and sentiment indicators). This framework is used to continually review the relative value of different asset classes, and it is summarized in Aon’s Medium-Term Views. Aon believes that medium-term views can be exploited as a source of investment performance.

Consider using Medium-Term Views to apply asset allocation tilts while staying within the investment policy. The Medium-Term Views can be used to influence decisions such as whether to rebalance to the target allocation or the edge of the policy range and where cash inflows and outflows should go.

Framework to review the relative value of different asset classes:

Valuation (e.g., price/earnings ratios),

Fundamentals (e.g., economic environment)

Market Awareness (e.g., technical and sentiment indicators)

2 Medium Term Views represents Aon’s outlooks on capital markets and economies over the next several years. These views are constructed based on our framework of analyzing fundamental, valuation and near-term drivers of capital markets.3 The Royal Swedish Academy of Sciences awarded the 2013 Nobel Prize in Economics to Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller. This site contains information that has been created, published, maintained or otherwise posted by institutions or organizations independent of AHIC. AHIC does not endorse, approve, certify or control these websites and does not assume responsibility for the accuracy, completeness or timeliness of the information located there.4 https://www.nobelprize.org/uploads/2018/06/popular-economicsciences2013.pdf

https://www.nobelprize.org/prizes/economic-sciences/2013/press-release/

https://www.nobelprize.org/uploads/2018/06/popular-economicsciences2013.pdf



3. Traditional Active Management

Traditional active management is the anchor of how most institutional investors try to add value over their passive benchmarks, and the active versus passive management debate is both nuanced and rich .

There are good reasons why this is a hotly-debated topic, and reasonable people fall on both ends of the spectrum. Our views on active vs. passive management are not rigid or ideological: they are based on research. We believe some investors are well-suited for active management, while others are likely to perform best with passive or factor-based investments. Suitability will vary based on both investor circumstances and asset class.

While we acknowledge the average active manager is likely to underperform after fees, we also believe that actively managed, long-only public equities are likely to add value for skilled investors willing to employ broad, high-conviction mandates (such as unconstrained global equities) and stick with them over the long-term. In an implementation, this typically requires blending multiple complimentary high conviction active managers to control risk at the portfolio level. However, many investors have difficulty attaining and maintaining these characteristics. They often end up closet-indexing to pay high fees for portfolios that look like the index, in which case they may be better off investing equities passively or using low-cost factor-based strategies.

Active management in fixed income has higher odds of success than equities, especially for broad, multi-sector mandates. Investors may be able to achieve some of the same returns as active management by using customized blends of the broad market, such as overweighting spread sectors. Passive mandates may make sense for those needing a high level of simplicity or liquidity.

Alternative investments have natural advantages for active management, and we believe most institutional investors’ allocations to alternatives are too small. The evidence is that skill and performance persistence is stronger in alternative assets than public markets. Diversification5 can increase with allocations to private real estate, private equity, and hedge funds. Those who can tolerate complexity, illiquidity, and cost should move toward substantial allocations to such assets. However, alternative assets have much greater differentiation in performance by manager, making it even more critical to have a strong process for manager selection.

5 Diversification does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.

Our views on active vs . passive management

are not rigid or ideological: they are based on research .



Reassess Risk ManagementSeeking investment opportunities must be balanced with risk management . Institutional investors should evaluate the relationship between the investment portfolio and the broader enterprise around it .

For some investors, such as healthcare organizations and university endowments, knowledge of liquidity pressure points may be essential to the enterprise and balance sheet. For pensions, the relationship between market downturns and contributions should be a key input to their investment decisions. Many corporate pension investors may prefer to reduce risk in the pension investments to focus their risk-taking within their core businesses.

Risk management should be disciplined and methodical. For example, pension plans with de-risking glide paths and hedge paths have triggers based on funded status and the level of interest rates to influence their portfolio strategy. This strategy allows the portfolio to quickly and automatically reflect new circumstances. The fiduciaries should meet and be informed of changes; we’ve found that the vast majority of the times, they are happy with how the portfolio is following the automatic triggers, but occasionally they tweak the strategy to make it better reflect their preferences. Regardless, having the investment policy statement reflect their views provides clarity on the default approach, which reduces the influence of behavioral biases when reviewing potential portfolio changes.

Risk management should be disciplined

and methodical .



Organizations concerned about major liquidity problems should review the options outlined in the IPS or other governance documents. For instance, is the organization able to access an established credit line? Is the portfolio liquidity likely to dry up in the same economic environments that additional stress will happen from changes to cash inflows and outflows?

If an organization is concerned about a significant issue with illiquidity occurring over a long period of volatility, it should conduct a liquidity study to help understand the scope of the problem. The liquidity study would analyze medium- and long-term liquidity risk through a stress test to see how far actual allocation could deviate from the targets – with the extreme result being that the portfolio runs out of liquid assets to cover cash outflows.

• Liquidity of private equity, private real estate, private debt and other private-market assets

• Changes in capital calls and distributions from closed-end private funds

• Sharp declines in the value of liquid public securities, which could mean a smaller asset pool from which to draw cash

• Gates being erected in private funds that are typically liquid during less volatile markets

• Changes in cash outflows and inflows during down markets

These stress tests are a key part of calibrating how much illiquid assets can be held, and they require a detailed analysis that considers:



Prepare for the Next Period of VolatilityA good starting point for an institutional investor to prepare for the next period of market volatility is to review how they did in the most recent one .

Was the investor able to navigate the environment well by rebalancing near market lows, pursuing market opportunities from dislocations, while managing liquidity and transaction costs well? Or was the investor caught flat-footed, missing opportunities or not executing well? If there are opportunities for improvement, how can the investment policy and other aspects of governance be adjusted to improve for the future?

Answering these questions is fundamentally about evaluating whether the investor has the resources and structure needed to execute their strategies effectively. In some cases, what is needed is a precise intervention – say, just adding an Opportunity Allocation to the investment policy. In other cases, more involved changes may be prudent.




Over the past several years, we’ve seen an increase in institutions questioning whether managing their investment program is something they should be doing on their own. Many organizations lack sufficient resources to manage their portfolios internally. They may not have the necessary speed of internal decision-making or the economies of scale to get the investment returns they want. They can focus on their area of expertise by delegating that responsibility to a full-time investment adviser, an Outsourced Chief Investment Officer (OCIO). Given the increased complexity of institutional investment programs, OCIOs can help investors access the expertise and scale needed to get the most out of their portfolios. For example, OCIOs can seamlessly implement strategies such as:

• Multi-manager high conviction active portfolios

• Alternative investments

• Opportunity Allocations

• De-risking glide paths and hedge paths

• Custom liability-hedging portfolios

• Medium-Term Views

All of these can often be done by an OCIO with less effort from the investor while offering attractive fees through economies of scale gained by negotiating asset manager fees based on the size of the entire OCIO platform.



What to consider when looking for an outsourced chief investment officer (OCIO):

• Does the OCIO have the scale and infrastructure to have many competencies and investment specialists?

• Can the OCIO access all asset classes and allocate the assets across a range of risks?

• How transparent is the OCIO’s pricing process?

• Does the OCIO have a financial incentive to include or exclude any particular investment manager or sell its own products?

• Does the OCIO have a history of generating returns and meeting client expectations?

Institutional investors should review their current governance procedures to see what they are good at and where there are gaps. If there are gaps, investors should consider different ways to fill them.

Down markets force investors to make sure they are asking the right questions, building portfolios that meet their needs and challenging the status quo. A systematic approach starts with getting a good handle on the governance structure that provides a framework for decision-making. Times of stress can reveal weaknesses that, when corrected, can position investors for a better future.




About Aon Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retirement and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance. For more information, please visit aon.com.

For more information about managing volatility, please visit Aon’s insights hub, or contact an Aon investment consultant:

Duke Williams IIInsurance Solutions LeaderAon [email protected]

Ed BardowskiSales LeaderAon [email protected]

Beth HalberstadtDefined Contribution Solutions LeaderAon [email protected]

Bryan WardNorth America Head of Solutions and SalesAon [email protected]

Calum MackenzieHead of Investment - CanadaAon [email protected]

Heather MyersNon-Profit Solutions LeaderAon [email protected]

Kristen DoyleHead of Public FundsAon [email protected]

http://www.aon.com

https://insights-north-america.aon.com/managing-volatility

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This document is appropriate solely for institutional investors. Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Consultants will be pleased to answer questions on its contents but cannot give individual financial advice. Individuals are recommended to seek independent financial advice in respect of their own personal circumstances. The information and opinions contained herein is given as of the date hereof and does not purport to give information as of any other date and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. The information contained herein is derived from proprietary and non-proprietary sources deemed by Aon to be reliable and are not necessarily all inclusive. Aon does not guarantee the accuracy or completeness of this information and cannot be held accountable for inaccurate data provided by third parties. Reliance upon information in this material is at the sole discretion of the reader.

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