A profound shift is taking place in the way pension plan fiduciaries manage market risk and help participants save for retirement. It is being driven by strategies that go beyond asset allocation and seek to actively account for changing market conditions, striving to protect growth in bull markets and defend against losses during major downturns.
Historically, most attempts at managing portfolio risk have relied heavily on asset allocation—diversifying exposure among asset classes that have exhibited low correlation to one another. This theory, however, has proven ineffective at certain points in time, especially when the economy is contracting.
In 2008, for example, nearly every major asset class was affected by the global downturn: U.S. equities were off 37%, international equities were off 45%, emerging markets were down 55%, real estate was down 37%, high-yield bonds lost 26% and commodities were down 37%.
Even hedge funds and private equities, which generally promise market outperformance, performed poorly. Alternative asset classes posted an average loss of 19% during the recent financial crisis.
Many experts believe the high correlation across many of the world’s major asset classes was not a black swan event, but rather the inherent reaction of ever-more-connected global economies. Additionally, broad access to historically successful “diversifiers” such as commodities reduced the correlation benefit that was once thought innate in such asset classes.
This played out during the months leading up to the 2008 crisis, when the market witnessed billions of dollars flow into newly created commodities-based, exchange-traded products that offered easy one-click access to a world previously available only to large institutional investors. In the months following the financial crisis, when many institutions and investors needed to raise capital to offset losses or simply fly to safety, a massive outflow in the commodities-based products caused the asset class to sell off in lockstep with many of its “low-correlated” counterparts.
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When evolution meets revolution
Since the 1952 publication of Harry Markowitz’s article Portfolio Selection, investors have relied on asset allocation strategies to reduce portfolio risk. During the economic booms, the success of diversification was praised. During the busts, its validity was questioned.
Though at the time of its writing Portfolio Selection was revolutionary, the world and its economies have evolved dramatically over the past 60 years. One example came through the development of financial futures contracts in the 1970s, which have provided institutional investors the ability to develop sophisticated hedging strategies to effectively mitigate market risk. Today, the financial futures market is one of the most transparent and liquid markets in the world, accounting for more than $1 trillion per day in contract value.
In fact, it was through the revolutionary use of a derivatives-based hedging strategy that one industry successfully weathered the 2008 financial crisis. During a time many struggled to find safety for their assets, one group outside of the pension industry—large insurance companies—was highly successful at managing equity market risk throughout the financial crisis (see Figure 1).
Large insurance companies within the variable annuity market discovered that the dynamic protection strategy they used to hedge their guarantees had saved the insurance industry more than $40 billion, and was 93% effective at achieving their designed goals, even during the worst months of the crisis, according to a recent Milliman research report.
Had a similar risk management strategy been applied to a 60% equity/40% bond pension plan, Milliman calculations show it would have captured 77% of the upside versus the unprotected portfolio during the bull market of 2003-2008 and, perhaps more impressively, successfully avoided 71% of the downside during the financial crisis of 2008.
Applying protection strategies to defined benefit pension plans
Defined benefit (DB) pension plans face significant and complex risks as they struggle to recover both from the asset losses sustained during the financial crisis and from the negative impact of today’s low interest rate environment. Current portfolios—commonly consisting of equities, bonds and alternative assets—do not employ sophisticated risk management techniques, leaving pension plans exposed to material losses in the event of a severe or sustained market decline. (See Figure 2.)
Pension plans that are considering de-risking their portfolios with bonds are reluctant to act with interest rates at historic lows. Bonds are often thought of as good de-risking tools because they normally provide stable returns. As it stands today, if credit spreads widen or interest rates rise sharply, a bond portfolio could become highly volatile and experience large losses.
Even in normal rate environments, bonds are inefficient tools for managing the equity risk of a portfolio. If, for example, a pension plan is not comfortable with following the market down dollar for dollar in a decline, and seeks to eliminate 40% of its downside exposure, it is generally accomplished through a fund with 60% equity exposure and 40% fixed income exposure.
As a result, the 60/40 fund only retains 60% of the downside exposure, but has also sacrificed 40% of the upside potential of equity investments. Hedging, on the other hand, allows the original portfolio to remain intact and can eliminate a greater proportion of downside risk while maintaining more of the upside potential.
Reaping gains, cushioning loss
Pension plans went into the financial crisis with average equity and alternatives exposure of 66%. Significant asset losses combined with the prolonged low interest rate environment have pushed pension plans to their lowest funding levels ever. The reality is many DB pension plans right now can’t afford not to take risk. These plans require substantial contributions and/or outsized asset returns in order to recover from past losses.
Unfortunately, the plans that most need strong asset returns have the least cushion to absorb losses from another major market decline. What these plans need is to participate in the upside potential of equity investments, but be protected against the downside losses in equities that accompany crisis events. The successful risk management techniques used by insurance companies throughout the 2000s show that upside participation with downside protection is indeed achievable.
Providing capital protection via hedge assets is a core risk management strategy. To maximize transparency and reliability, highly liquid exchange-traded equity index futures contracts may be used. These contracts cash settle on a daily basis. With this type of capital protection strategy in place, cash gains on the futures contracts during declining markets can mitigate losses in underlying equity investments.
The capital protection strategy can be managed to automatically lock in gains from favorable returns on underlying investments and to harvest gains from the hedge portfolio during severe market corrections. This strategy avoids value-destroying behaviors such as buying high and selling low.
The hedge assets can operate as an overlay, acting independently of the underlying portfolio, allowing investors to remain invested in current assets. By integrating hedge assets with the underlying investments, risk can be reduced and the overall value of the portfolio may be enhanced over market cycles.
The presence of a capital protection strategy within a portfolio is of great value in a crisis, but it will drag down returns in a stable, rising market. Pension plans need a risk management strategy that allows for significant upside potential and that can be maintained across market cycles.
Many tail-risk strategies in the past have focused on the purchase of put option contracts to establish a floor on the portfolio. These types of tail-risk strategies work well in a crisis, if the investment bank selling the option can maintain solvency throughout the crisis, but they tend to be expensive when the markets are stable and rising.
Because the market has historically been known to spend years at a time in such an environment (e.g., 1980-1987, 1990-1998, 2003-2007) the expensive premiums paid for put option protection create a significant cumulative drag on the overall portfolio value. These strategies, so good in a crisis, are usually a poor fit for portfolios if maintained across market cycles.
One solution is to combine capital protection with a volatility management strategy—adjusting portfolio exposures between high-risk assets (equities) and low-risk assets (bonds) in order to target a defined level of risk, or volatility. It works by forecasting near-term volatility and reducing or increasing equity exposure accordingly to maintain a certain target level of volatility.
The average realized volatility of a diversified U.S. equity investment is around 18%, and the average volatility of a core bond investment is about 4%. This means that the typical 60/40 portfolio should expect to realize volatility of 12% over a long time horizon. But over shorter time periods, a 60/40 portfolio may experience volatility ranging from 5% (Q3 of 2005) to 40% (Q4 of 2008).
Recognizing that the majority of investment strategies are primarily interested in managing their exposure to risk of loss—and not specifically to equity allocation—leads to the conclusion that equity allocation should be manipulated in order to maintain a given level of risk.
This common-sense argument that focuses on using an actual measure of risk tolerance (volatility) as opposed to a risk proxy (equity allocation) resonates with many investors. But volatility management is also a very powerful—and greatly underutilized—risk management tool on its own, because not only do significant market losses typically occur in periods of high market volatility, but periods of sustained market gains frequently occur in combination with low prevailing volatility. (See Figure 3.)
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Combining volatility management with a capital protection strategy improves the downside protection in the typical high-volatility market crash and improves the upside participation in prolonged stable, rising markets.
Overall, allowing for a carefully portioned dose of equity exposure combined with a protection strategy that cushions against equity losses has the ability to maintain a pension plan’s investment in equities while providing much greater certainty that the plan can avoid large losses during market downturns. History has shown that this strategy has created a much more effective hedging solution than asset allocation alone.
The declining effectiveness of conventional risk management and the revolutionary approach of new risk management strategies have the potential to transform the way people manage risk and save for retirement. Simply put, there is a better way to manage market risk and offer pensioners prosperity in retirement.
It appears that the U.S. economy is starting to pick up steam after many months of tepid business activity and high unemployment. Many pundits are predicting strong gains in equity markets for 2012. However, the potential for market volatility from the European debt crisis, Iran’s nuclear ambitions and continued gridlock in Washington, D.C., to name a few influential factors, are not far from the minds of investors. Fixed income rates show no signs of increasing in the near term.
The concept of portfolio protection can be combined with liability-driven investment strategies meant to target the other source of pain being inflicted upon pension plan portfolios: low and stagnant interest rates. It allows pension plans to remain invested in equities, which carry the promise of high returns and have the best ability to lower the long-term cost of the plan. Simply put, portfolio protection strategies offer an effective tool to mitigate market risk.
Numerous investment consultancies and investment houses have developed variations on the theme described above. Plan fiduciaries, charged with the responsibility to grow and nurture defined benefit plan portfolios, endowments and other trust funds, should approach these strategies with interest and consider them in the performance of their duties.
Reprinted with permission from FINANCIAL EXECUTIVE, April 2012, © by Financial Executives International; 1750 Headquarters Plaza, West Tower, 7th Floor, Morristown, NJ 07960; 973.765.1000; www.financialexecutives.org.