2018 will probably be remembered as the year volatility returned to the market. As highlighted in our CIO's investment outlook, there are a number of tail risks on the horizon that could cause this to continue. While there is no panacea for market volatility, these four simple steps can help reduce the impact.
Here's an example pension scheme and show the effect of diversification on risk.
The scheme’s initial portfolio (on the left) is a classic 60:40 split of equity and bonds which we would expect to achieve 2.7% yield per annum over its gilt-based liabilities over the long term. The scheme is exposed to significant downside risk with the funding level expected to drop by around 24% when simulated through the financial crisis (2007-2009) or by around 7% through the tech bubble (2000-2001). In the right hand portfolio, we have diversified the asset allocation. The expected rate of return is unchanged but the risk (measured by impact during the financial crisis) has been reduced by c.44%. Simply diversifying has significantly improved the risk/return efficiency of the portfolio. So much so that funding levels actually increase by 1.3% through our tech bubble simulation.
Diversification is not a new concept and UK pension schemes have certainly made improvements in this area. However, we believe there is still room for further improvement. For example, schemes with an AUM of under £10 million still have, on average, 40% of their equity exposure in UK equities. This compares to just 15% for schemes that are over £1 billion. This leaves smaller schemes in a higher risk position where they are more susceptible to UK-centric shocks.
Trustees face the challenge of balancing required exposure to growth assets with allocating to government bonds to reduce liability risk. This is where incorporating leverage, through swaps or synthetic bonds, can be a vital risk reduction tool. Returning to the example scheme, the diversified portfolio only hedges 35% of the scheme’s liability risk owing to the low government bond allocation. However the liability hedge ratio could be increased to 80% by using leverage. This would reduce the risk (measured as expected funding level drop over a one-year period, in a 1-in-20 event) by a further 10%, whilst still maintaining a similar expected return.
The drawback of leverage is it requires the scheme to maintain sufficient collateral. This requirement for cash has been exacerbated by more and more pension schemes becoming cashflow negative. It goes without saying that ensuring efficient collateral management is a key part of the solution. Additionally employing a cashflow aware approach can help schemes mitigate this risk. Cashflow negative schemes can be adversely affected during periods of heightened volatility where they need to liquidate assets to pay pensions. This can be at prices that may have strayed significantly from “fair value” and so losses are crystallised. Moving towards a cashflow matched portfolio not only reduces this early sale risk but also reduces re-investment risk.
A bonus of diversifying assets globally is this leads to foreign currency exposure. Choosing a currency hedge ratio is not an exact science but we believe maintaining some exposure to foreign currency is an important risk mitigation tool. This is because of the exposure to safe-haven currencies such as the US dollar, Japanese yen and Swiss franc, which have historically been known to rally when there are market downturns.
For more detail on how DB schemes can manage risk in turbulent times, please see our research article.
Factor investing resembles the 1966 epic Spaghetti Western film, “The Good, The Bad and The Ugly", with factors having historically performed differently in various economic conditions.