Nigeria’s pension fund administrators have favoured the fixed income market for 13 years, adopting a near 100% allocation to debt instruments. Despite fixed income profitability, long trends and studies from portfolio managers show a considerable risk of capital loss.
Predicting investment outcomes is an arduous undertaking since economic and financial variables change for market players without warning. Empirical evidence, sensory evaluation, and some luck thus tend to influence asset class allocation of capital.
Hence, in the absence of definitive empirical evidence, the Nigerian Pension Commission (“PENCOM”) guidelines are an anathema. In Nigeria, mutual fund managers have their investment guidelines, and pension fund administrators (“PFAs”) have guidelines stipulated by PENCOM in the quest for meaningful return and asset allocation.
These were disclosed in a study titled “The Curious Case of Nigerian Asset Allocations,” published in 2021 by Author, Oladayo Oduwole. The study reviews the results of different asset allocation schemes in Nigeria over the last 35 years. Nigerian equities have generated an average annual real return of 3.52% in the previous 35 years without including dividends.
During the review period, the Nigerian economy experienced periods of excessive inflation, causing bills and bond returns to fall behind. Bonds and bills have yielded a negative real return. If appropriate inflation management measures are implemented, Nigeria’s long-run inflation rate is anticipated to move downwards from its 35-year average of 18.20%.
According to this research, despite the greater rate of return on stocks, the significant market decline in the previous decade and a half has resulted in a reduction in terminal portfolio levels for biased equity portfolios. With negative returns on bills and bonds for the last 35 years, portfolio managers may need to rethink their asset choices.
What are Nigerians currently holding?
According to the report, “financial assets in Nigeria held by mutual fund managers and PFA’s are currently lopsided with a skew towards bonds and bond-like instruments. This type of pronounced allocation is problematic because it is at odds with long term empirical asset returns and may lead to reduced terminal wealth levels for retirees if the equity asset class performs better over the next two decades.”
Nigerian-style asset allocations today
In Nigeria, equity contributions to pension assets have decreased from 30% to 9% during the previous 13 years. The present rules given by PENCOM to fund administrators show a bias for government securities. Should a government regulator be biased in favour of government securities, although the asset class’s historical actual returns have been damaging? The present PENCOM investing standards establish a worldwide limit of 70% in government securities for fund II assets. Before 2010, the global limit for retirement savings account investments was 100%, according to Itodo (2014).
Over the previous 35 years, the most straightforward approach for Nigerians has been to invest mainly in debt instruments in the hopes of increasing contributions to their portfolio. A more sophisticated system incorporating a bond and an option, known as a PPN (Principal Protected Notes) beats the debt-only strategy since it captures the best equity returns while avoiding the severe drawdowns experienced in 2008 and the following years. The PPN strategy also has the most significant cash return multiple of any equity or debt allocation approach.
What do we know about the historical world and Nigerian asset returns?
According to the report, in 2019, a group of researchers published, “a rate of return on everything,” the results found that within 16 advanced economies since 1950, equities have delivered the highest rate of return followed by housing with government bills returning the lowest rate of return. Equities returned in absolute terms 9.45% per annum. The work of the researchers covered a period of 1870 to 2015, with returns being reported in dollar terms.
For the “world returns,” pre-1950, housing delivered the highest rate of return to investors or asset holders. If the history of the last 145 years were to repeat itself, then the presented rates of return should reoccur with slight variation.
In Nigeria, the recorded history of financial instruments is much shorter. The Lagos stock exchange was incorporated in September 1960, with trading commencing in June 1961 with six government bonds, one industrial stock, and three equities. The Lagos stock exchange price index was only computed starting in 1984.
From 1985 to 2020, equities returned 3.52% in real terms annually versus bonds bearing negative 2.51% in real terms and bills performing much worse with negative 4.37% in real terms, annually. The equity return was derived from the Nigerian all share index, published by the Nigerian Stock Exchange; bills are from average historic treasury bill rates, and bonds returns are a blend of several federal government instruments and the S&P/FMDQ Nigeria sovereign bond index over the review period.
Is there a correct portfolio allocation?
The report stated, “It is difficult to say that a right or wrong allocation of assets for a portfolio exists. Allocations are subject to various factors; however, one can suggest the types of allocation that may generate the highest risk-adjusted return.
Finance literature suggests various allocations; Thaler and Williamson (1994) suggest a 100% equity allocation in a portfolio to generate the highest risk-adjusted return regardless of the evident drawdowns. Asness (1996) suggests a levered 60 / 40 scheme, where 60% is invested in equities and 40% in bonds but with the portfolio levered.
Traditionally, investors have been urged to hold a 60/40 allocation and other variants in the management of their portfolios.”
What the report is saying
The near 100% capital allocation to fixed-income securities in Nigeria has been beneficial in the last 13 years (2007 — 2020).
However, a review over 35 years suggests that a more sophisticated asset allocation scheme may be a more sustainable approach for allocating capital. Considering other markets with longer histories, the primary debt allocation scheme may be problematic in the mid-term.
The report said, “It is expected that a dynamic reallocation favourable to equity and equity-like opportunities will be pursued going forward. Questions need to be asked about the formulation of the PENCOM guidelines as they do not conform with empirical evidence on real returns and allocations towards assets with the highest real returns.
The last 35 years in Nigeria have shown that investors’ portfolios should be skewed in favour of equity investments, emphasizing the potential drawdowns that drag down investor returns.
A straightforward hedging scheme should be introduced into the pension investible asset mix. The current allocation could lead to terminal wealth levels 10% to 20% lower than they need to be. For those looking to improve performance, a well-balanced portfolio of foreign equities and some commodity contracts for the de-carbonized economy could enhance performance in the long run.
An insistence by the regulator on its guidelines may require a catchup fund should it be proven two decades into the future that the specified allocations were problematic and flawed.”
What are the experts saying?
Udegbunam Dumebi, a fixed income trader at United Bank for Africa Plc stated that the Nigerian situation is more complex due to the high levels of uncertainty in the economy and the stock market.
“Although diversifying your portfolio is a good idea, loss aversion plays a huge role for investors. This is because the uncertainty in the stock exchange market may lead to investors losing all their money. However, this is not the case in the Nigerian fixed-income market. Hence, the fund managers should be responsive to the dynamics of the Nigerian market and only favour more stocks when there is a strong hint of economic normalcy,” he said.