THE funds management industry is poised for a sea change in the way assets are allocated, says Schroders plc group chief investment officer Alan Brown, who was in Singapore earlier this week.

At least two traditional practices must change, he says. One is the overemphasis on market benchmarks to measure performance. The second is the discipline of a fairly static strategic asset allocation, which should give way to a more 'dynamic' approach. Related to the latter is a shift towards a more dynamic approach towards clients' risk appetite.

Mr Brown says that investors, consultants and even asset managers spend an inordinate amount of time scrutinising funds' performance relative to their market benchmarks - which really isn't the crux of the issue.

'At the end of the day, all investors have some real world goal which is not market related. There is an implicit view that clients want to earn the benchmark plus a bit. But why should they want to earn the market return?'

For a pension fund or insurance company, the goal is to make sure assets cover its stream of future liabilities. For individuals, a retirement fund must likewise be able to fund expenses in retirement.

The risk that investors and managers should be more concerned about is that markets may not deliver the rate of return needed to fund their liabilities.

In the last 40 years, actual returns have departed from forecast returns. Forecasts are traditionally based on the Gordon growth model which takes into account dividend yields and an assumed growth rate. In the 1970s, the actual return of the decade was an annualised minus 1.7 per cent, against a forecast 7.2 per cent. Between 2000 and 2008, the actual return was minus 2.8 per cent against the forecast 2.7 per cent.

In the 1980s and 1990s, actual returns beat forecast returns by a good margin.

Says Mr Brown: 'If you had a 40-year investment horizon, you would have done just fine. But most of us don't have 40 years and 10 years is a long time to be wrong. We need to be better at this.'

Those who urge investors to stay invested often cite data to show that missing the market's 10 best days would cause you to lag the market. But the data also shows that if you sold an investment 100 days before the 10 best days, and waited 100 days after the best days to reinvest, you actually outperformed.

'The forecast that consultants use for asset classes barely change over time, yet the reality is returns move around a great deal. We need to take a view on whether the returns prospects from assets are likely to be good or bad,' says Mr Brown. 'If you have a five to 10-year horizon, you need to worry about valuation effects and whether those are likely to be positive or negative.'

Wealth-destructive decisions

The key then is to monitor the points at which markets appear to be significantly over- or undervalued, which would trigger an asset allocation shift. This is where there is some good news. Coming from a decade of poor returns, some models - such as Robert Shiller's PE model which adjusts PEs for cyclical factors over 10-year periods - indicate that returns based on the US market may actually exceed 10 per cent per annum. The latter is also suggested by Bogle's model.

'It's not the highest return, but it meets inflation plus five (per cent) handsomely. If I'm an investment manager, I may be cautious but I'd at least want to be neutral in my equity exposure today. As asset managers, we have to take these indicators and not allow emotions to get in the way too much.'

Schroder itself has near-term concerns and believes that economic recovery in 2010 is likely to disappoint. Still, the firm maintains a neutral weighting in equities, within which it is invested in 'high beta' areas such as emerging markets and the Asia-Pacific region. Add to that a fairly large credit exposure, and the firm is effectively overweight equities, albeit not directly.

The other aspect to monitor is clients' risk appetites, which are likely to change along with shifts in the market and their wealth levels.

Meanwhile, Mr Brown believes that fund managers will have to take a more holistic approach to clients' assets, as opposed to the current practice of focusing only on specific segments in which their skills may lie, such as in emerging market equities. Investment reviews going forward will have to address the big question of how well the portfolio is able to meet a client's funding needs, rather than specific segmental performance.

'This is a multi-asset problem. Firms have to reorganise themselves if they want to avoid being limited to being a component provider. This will change the relationship between consultants and investment managers. We're being asked to discuss holistic issues more than we have in the past.'

At the moment, some US$26 billion of Schroders' assets in balanced mandates could move in this direction, he says. Schroders manages a total of roughly US$186 billion in assets.

As for retail investors, Mr Brown bemoans their tendency towards knee-jerk reactions as fear and greed nudge them towards wealth-destructive decisions. 'The terrible challenge for individuals is that they are very prone to major behavioural biases . . . If our favourite share fell 25 per cent, we wouldn't feel good. Our instinct isn't to buy more but to sell.

'When we buy an investment, if we were buying into earnings and dividends that we can expect to earn to infinity, it will be unambiguously good that we can buy them cheaply. But the fact that we feel sick is because we want to sell at a higher price next week.

'The biggest thing individuals can do - or we as investors can do on behalf of individuals - is to fight that tendency, to try to stop people making terrible wealth-reducing decisions to sell when assets are falling and buy when assets are up.'