A multi-asset class approach to pension fund investments.

• Author: Engebretson, Kathryn J.

A system for building a portfolio that provides the highest possible return consistent with an acceptable level of risk.

Most analysts project that the returns available to investors in the capital markets in the upcoming decade probably will not be as attractive as those of the past decade. Yet, in many cases, pension fund and other liabilities will continue to grow at their historical rates. Public plan sponsors could find themselves faced with the unpleasant choices of contributing additional cash from other sources to meet pension fund payment obligations or increasing the risk profile of their current investment program in hopes of achieving a higher return.

There is an alternative strategy for increasing returns without increasing the associated risk, thanks to the conclusions of modern portfolio theory. The purpose of this article is to review the basic tenets of modern portfolio theory and to show how the addition of new asset classes, even those which are riskier in and of themselves, to an existing portfolio may provide incremental returns without incurring additional risk.

Historical Rates of Return

Exhibit 1 shows returns and risk for a number of asset classes for the most recent five- and 10-year periods and also for the period since World War II. Risk is measured by the standard deviation, or variability, of returns. Current forecasts suggest that returns for the upcoming decade will more closely mirror those of the longer term than those of the previous decade. Both during the last 10 years and historically, stocks have outperformed bonds, and international investments have outperformed their domestic counterparts. Not surprisingly, those asset classes with the highest rates of return also have tended to exhibit the most risk.

Modern Portfolio Theory

Modern portfolio theory was initially developed by Harry Markowitz, an economist who studied the financial markets, and presented in a pioneering paper in 1956. During the past four decades, much of the research in portfolio management has centered on ways to implement this theory, which suggests that introducing modest amounts of riskier [TABULAR DATA OMITTED] asset classes into a portfolio actually can have a risk-reducing effect due to the impact of diversification.

Because the performance of separate asset classes is affected by different factors, their rates and patterns of return are distinct from one another. To use a more technical term, the returns of these asset classes are not highly correlated with each other. The correlation between two assets measures the extent to which their returns move together. Another way to think about correlation is as a measure of the extent to which returns in one asset class may be used to predict returns in another asset [TABULAR DATA OMITTED] class. For example, two assets whose returns move in identical patterns have a correlation of 1. Two assets whose returns move in opposite directions have a correlation of -1. Modern portfolio theory suggests that adding assets that have low correlations with the returns on an existing portfolio will result in overall returns that are more stable, or less risky, over time.

What are the...