It is widely accepted that asset allocation is one of the most important—if not the most important—decisions dictating an investor’s success (and risk). This requires a long-term outlook. The constraints of a formal asset allocation policy should not, however, impede investors’ ability to implement attractive opportunities or innovative ideas as they arise.
An Opportunity Allocation is not an investment in and of itself; rather, it is part of an investor’s governance structure to help facilitate great ideas getting into the portfolio.
We recommend investors consider an Opportunity Allocation as a way to be nimble and take advantage of market opportunities. An Opportunity Allocation is not an investment in and of itself; rather, it is part of an investor’s governance structure to help facilitate great ideas getting into the portfolio. An Opportunity Allocation is flexibility created in the investment policy statement that allows investors to make investments that may not fit within a traditional asset allocation construct.
This approach isn’t for every investor, since individual investors’ governance and circumstances can strongly influence the merits of the approach. However, where it is a good fit for the investor, an Opportunity Allocation can be compelling.
Examples of Investments That Might Be Included
Although the nature of Opportunity Allocations means that any investment could be included, it is illustrative to list some examples of the types of investments that were likely to have been in Opportunity Allocations historically or might be included now:
- Distressed credit and bank loans (2009–2010). The liquidity squeeze that occurred during the global financial crisis drove forced selling by banks, hedge funds and other investors, which depressed pricing for these investments to the point at which pricing appeared unusually attractive.
- Insurance-linked securities (2017– present). Investments in catastrophe reinsurance can generate attractive returns that are generally uncorrelated with the financial market. While this strategy can be compelling on a strategic basis, it can also be deployed opportunistically, as events that deplete insurance company reserves can increase demand for reinsurance, pushing up reinsurance premiums. We saw a strong opportunity for this after the 2017 hurricane season.
- Bank capital relief (2018–present). New European banking regulations brought about by the global financial crisis have forced banks to take measures to repair their balance sheets and improve their capital ratios. Bank capital relief emerged as a strategy to address this issue. We believe it offers the potential for a relatively high and sustainable income of around 8% per annum for investors willing to lock up capital for five years or more. It should exhibit low performance volatility and have low correlation with other illiquid credit opportunities. This strategy provides sufficient reduction in a bank’s capital requirements to support sustainable excess returns versus risk.
Implementing an Opportunity Allocation
Aon recommends designing the Opportunity Allocation as a maximum allocation as opposed to a target. That is, the target allocation should be 0%, so there is no pressure to add investments simply to fill the allocation. Typically, a range of 0-10% of total fund assets is a reasonable approach.
Governance and Execution
A critical element to effectively execute strategies within an Opportunity Allocation is an appropriate and nimble governance structure. Stated bluntly, such an allocation likely will be less effective if decisions have to be vetted and approved in a cumbersome and bureaucratic decision making process.
If instituted, we believe the governance structure should allow a small group of decision-makers (either at the staff or committee level, or through an outsourced chief investment officer (OCIO) structure) the discretion to invest in the Opportunity Allocation, subject to general constraints on investment such as total size in dollars or as a percentage of total fund assets. Such a structure enables nimble decision-making and avoids “group think.”
Other Challenges Associated with an Opportunity Allocation
Listed below are some of the other major challenges associated with initiating an Opportunity Allocation:
- Reallocation during market stress
- Time/objective defined
Aon’s clients have used the Opportunity Allocation concept for more than a decade. We view it as a governance structure that allows institutional investors to capitalize on investment opportunities that are time sensitive or don’t fit well into a traditional asset allocation bucket. With the continued development of new products and the almost certain periodic dislocations in financial markets, Aon believes the investment universe for the Opportunity Allocation concept will continue to grow over time.