Gardner: How to win by not losing
Many pension funds have seen their assets perform well over the past three years, benefiting from rising values across financial markets in almost all asset classes.
Global equity markets are up more than 40 per cent and investment-grade credit has risen by 25 per cent. As a result, corporate pension funding levels have improved.
Many assets now look above fair value and in some cases expensive
However, funding levels have not improved by as much as you would expect, as bond yields have not risen as high as the market anticpated. For example, three years ago markets were expecting 30-year gilt rates to be 4.7 per cent in 2014, versus 3.3 per cent today.
Pension funds still need to invest in assets that generate sufficient investment returns for them to reach full funding.
The challenge is that many assets now look above fair value and in some cases expensive. Historically, pension funds would look to bank the performance of their equities, reduce risk and diversify into other asset classes – credit and infrastructure debt were popular last year, for instance.
However, demand for these assets has been strong over the past year, which means many of these assets no longer look as good value on an absolute basis.
On a relative basis, however, there is still value in credit by moving into illiquid and non-core markets.
Faced with the prospect of tighter monetary policy and unknown economic consequences from growing geopolitical tension, the continued rise of equity markets cannot be guaranteed.
When it is difficult to find value in growth assets, it may be a sign to consider safeguarding your assets against declining prices. An alternative strategy to stay invested in equities is to seek protection on the downside.
A number of pension funds are now looking at ways to dampen their equity downside risk. One area that does look good value is equity market volatility, as measured by the Vix volatility index.
At less than 12 per cent, the Vix is at its lowest level in a decade. This is certainly a cost-effective way to get protection for the next year. Pension funds looking for a more strategic long-term allocation to equities with downside protection can switch into a risk-controlled equity index.
These target a specific level of risk by dynamically varying the weights of an underlying equity index and a cash component.
This has two major benefits: it enhances the risk-adjusted performance of equities and it allows the pension fund to buy long-term affordable downside protection.
With fair-value assets becoming more difficult to find, finding value may become a case of winning by not losing.
Rob Gardner is co-CEO at consultancy Redington