How underpricing political risk could hit pension funds

In any uncertain economic environment, pension managers need to think about risk by focusing on a number of possible scenarios.

It is important to account for the extent that each scenario deviates from a central or base-case scenario, as well as the probability of each event occurring.

There are three broad stages a pension fund could consider when looking at risk and asset allocation.

At the most basic level, pension funds should have an idea of both the amount of volatility they are prepared to accept and the potential downside risk in terms of the total assets they can tolerate.

Trustees must focus on security selection to truly understand the impact that each holding might have on the overall performance of the scheme

Greece may not be material to most pension funds' asset allocations, but a potential Brexit would have significant effects.

A pension fund's overall asset allocation and exposure to UK and Europe ex-UK equities should be designed to account for the impact of any one-off event.

Taking a tactical view

In times of uncertainty, many pension fund managers take the opportunity to reassess the overall asset allocation of the scheme.

This often leads to a healthy rebalancing, or the elimination of potential areas of underperformance.

However, before any pension fund undertakes a change to its asset allocation, it is important to have an existing governance budget and a skill-set that can implement tactical decisions quickly and effectively.

The right solution depends on the governance and resources available.

The importance of security selection

When it comes to broad-based macro events, such as a Brexit or Grexit, individual security exposures are often overlooked.

Trustees must focus on security selection to truly understand the impact each holding might have on the overall performance of the scheme.

Careful security selection can also help to manage shifting correlations between asset classes, particularly in times of stress when behaviours tend to converge.

Active managers can balance movements in one asset class to partially mitigate movements in others, reducing the average volatility of a portfolio.

Greece might be only a very small component of European markets but, like a Brexit, a Grexit still represents potential issues in respect of funds’ European equity and fixed income allocations.

The prospects for UK and European companies may not necessarily be the same across sectors, as is the case within the UK equity market, where mining, energy and financial companies dominate.

While the outcome of the Brexit vote is likely to impact most financials, the fortunes of mining and energy companies are more closely tied to the respective commodity prices.

Fixed income

From a fixed income perspective, a Brexit will be more relevant to UK pension funds given their large exposure to the gilts market.

There will likely be some volatility as the referendum nears, and we could see significant volatility if the vote results in an exit.

There is also going to be pressure on the pound, so it is relevant to understand any currency exposures embedded in pension allocations or strategies.

So while valuations in European markets do not look egregious overall, some areas will be more impacted than others.

As we have witnessed with some recent political events, investors often underprice political risk, which leads to volatile markets in the short term. 

However, the best opportunities exist for those schemes willing to exploit a longer investment horizon.

Madeline Forrester is managing director for UK Institutional Business at MFS Investment Management