Choppy waters: How schemes can invest in volatile markets

Asset managers say institutional investors should be prepared for a longer period of low growth, interspersed with periods of turbulence.

Valentijn van Nieuwenhuijzen, head of multi-asset at NN Investment Partners, says: “Economic recovery will be slow and long-lasting... and interspersed with choppy periods for the foreseeable future.”

The ability of pension schemes to crystallise gains, cut losses and rapidly allocate capital to new opportunities is a vital skill in these market conditions

Tamsin Evans, P-Solve

These periods of volatility will persist because regulation has resulted in major structural changes in financial markets. Tamsin Evans, managing director of multi-asset at consultancy P-Solve, says: “Some major market players, such as investment banks and hedge funds, have reduced their trading operations, which has reduced the stability of financial markets.”

The combination of lower growth rates and bouts of market choppiness make managing a pension fund a tougher job. If a pension scheme loses 20 per cent of its value from a market correction, it will need to increase that value by 25 per cent to get back to where it was initially.

Richard Dowell, head of clients at Cardano, says: “In a world of low returns, that will take a long time to achieve.”

Reduce unrewarded risks

To avoid this scenario, the pension fund should be made more resilient to market shocks. “That means reducing the exposure to unrewarded risks,” Dowell says. Interest-rate and inflation risk have the largest impact on the value of a pension scheme. If a scheme has not put sufficient hedging in place, this should be addressed, he says.

Once pension schemes have put the necessary interest-rate and inflation risk strategies in place, they should ensure the rest of the portfolio creates real returns. An allocation to equities will help a scheme to achieve this target.

But pension schemes should be more nimble in their approach to allocating capital to this asset class. Jignesh Sheth, investment consulting director at JLT Employee Benefits, says: “Pension funds should take profits when values have peaked and reinvest after the market has corrected.”

Not only does this approach ensure a pension scheme always acquires its equities at fair value, but it also helps a fund manage its exposure to equity market volatility.

Sheth says: “Reducing the exposure to equities when they start to look overvalued will help protect that fund from any market correction.” This is perhaps the simplest and cheapest way to manage this risk, he adds.

Evans agrees: “The ability of pension schemes to crystallise gains, cut losses and rapidly allocate capital to new opportunities is a vital skill in these market conditions.”

A more dynamic approach to equity allocation, however, requires a scheme to react quickly. Sheth says: “Either a scheme needs sufficient governance to be able to manage this in-house or this needs to be outsourced to an asset manager, such as a diversified growth fund.”

A pension scheme should also be realistic about the level of returns equities can generate in an environment of low economic growth. Sheth says: “Additional returns can be found from credit assets such as high-yield bonds, secured loans and emerging market debt.”

An active manager can cherry-pick those assets with the lowest credit risk to provide a predictable stream of returns to the pension scheme, he adds.

As well as being more nimble and dynamic, the prolonged period of market choppiness means pension schemes should be less dependent on market beta to drive returns. Evans says: “The increased volatility makes seeking alternative sources of returns very important.”

Rather than relying on passive equity investment and momentum to grow investment returns, pension schemes should be looking for active strategies that can generate alpha. Evans says: “Pension schemes need to be very clear about what they want from an alpha manager to ensure they make the right fund selection.”

Striking a balance

Some asset managers suggest pension schemes should step away from a traditional portfolio construction towards one with a risk-balanced approach, where the proportion of assets in the portfolio is determined by their risk rather than their reward metrics.

Erik Knutzen, chief investment officer of multi-asset class at investment manager Neuberger Berman, says: “This will create a more balanced exposure to different risk factors.”

For example, rather than having a traditional portfolio with a static allocation of 60 per cent invested in equities and 40 per cent in fixed income, a risk-balanced portfolio would be dynamically managed according the changing market environment.

Knutzen says: “If the pension fund wants equities to contribute 60 per cent of the risk to the portfolio, then the capital allocation to equities will be adjusted to maintain that target.” If leverage can be used then other assets such as fixed income and commodities can be a more meaningful part of that portfolio solution.

Knutzen says: “From the perspective of a pension scheme, the strength of this approach is to create a much smoother series of returns than more traditional asset allocation models.”

Another approach to building a risk-adjusted portfolio to provide smoother returns is to focus less on diversifying assets and more on diversified sources of risk premia.

Certain assets have specific characteristics that have historically resulted in them producing higher returns than the market. Well-known examples are value and momentum. These are often described as investment factors.

Willem van Dommelen, head of multi-asset systematic strategies at NN IP, says: “Using investment factors allows a portfolio manager to build a more diversified portfolio with fewer correlations than other approaches.”

This more balanced approach will allow the fund to generate smoother returns regardless of the particular economic scenario. “This will be an all-weather portfolio.”

But to achieve this it is important to construct a portfolio that balances risk well. By analysing the volatility of different investment factors and measuring their relative correlations, the manager can ensure the portfolio is not over-exposed to a particular risk, which makes the portfolio particularly robust in a choppy market environment, he adds.

Charlotte Moore is a freelance journalist