Concerned by volatility? Keep calm and carry on

20 Nov 2015

By Alex Lindenberg

A disciplined approach can help pension scheme trustees and their corporate sponsors to sleep more soundly in volatile markets.

How will markets react to the first Federal Reserve interest rate hike since 2006? Will China’s policymakers engineer a “soft landing” from its credit boom? After a relatively benign three years, volatility returned with a bang in August as investors grappled with these questions. If these are tough calls for seasoned fund managers, how can pension schemes hope to effectively adapt their investment strategy in response?

Below we suggest seven key principles:

1. Keep calm. Don’t panic over immaterial risks; deal with the ones that may hurt you. As long-term investors, pension schemes have more capacity to weather volatility than other market participants. This is especially relevant to contractual assets, like investment-grade corporate bonds. Mark-to-market losses (caused by widening credit spreads) have historically tended to overstate losses (caused by corporate defaults) if these bonds are held to maturity and are offset (usually) by higher expected returns.

2. Focus on the long-term investment objectives. Timely and clear monitoring of performance against the scheme’s key metrics will help to avoid knee-jerk reactions. Schemes should assess their required level of investment return (vs. expected return on assets) and the risk being run (vs. the agreed risk budget). This helps to reframe the question from “what will markets do next?” to “what action do we need to take to stay on track”? The answer might be “nothing”.

3. Agree actions in advance. Volatility creates opportunities as well as risks – unexpected funding level gains may allow schemes to de-risk ahead of plan and secure a smoother path to their funding objective. The right governance structure is essential. Writing down a clear set of actions to take in response to agreed triggers and delegating implementation to a sub-group of trustees (or asset manager) will help schemes to respond quickly, calmly and objectively in turbulent markets.

4. Remove unrewarded risks. Ensuring that all investment risks are run with a long-term expected return can reduce the pressure on trustees to respond tactically in volatile markets. Where a scheme has decided to incorporate short-term market views into the strategy (e.g. around the direction of the interest rates), trustees should assess whether this position is right-sized compared to the other investment risks.

5. Diversify return sources. Rising volatility often means rising correlations between asset classes. However, investing in a broad basket of risk premia can mean the difference between a manageable funding level fall and a more severe shock. Strategies with low correlations to the economic cycle (e.g. trend following funds) or a strong relative value focus (some diversified growth funds) can be particularly effective in smoothing returns.

6. Control individual risks. Pension schemes may find that the volatility of their equity allocation varies significantly over time as market conditions change. A volatility control strategy, which keeps equity volatility roughly constant by adjusting exposure over time, can address this issue while delivering comparable expected returns.

7. Access affordable downside protection. A key benefit of volatility controlled approaches is they enable investors to buy downside protection at more affordable levels (c.1% option cost per year vs. 4-6% on a global equity index), while providing certain protection against sharp market falls.

Disciplined application of these principles can help pension schemes to design an investment strategy and governance process that is resilient across all market environments.

Alex Lindenberg is senior vice president, investment consulting at Redington

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