How to navigate hypervolatility in equity markets

The expansion of central bank balance sheets since the crisis helped suppress market volatility, yet its withdrawal may trigger its reappearance further.  Therefore, trustees should be prepared for continued market volatility and pension schemes should consider how they are positioned in light of this.

An examination of past volatile market periods teaches us several lessons about how to navigate the current period of stock market uncertainty. There are four key considerations for trustees: the importance of diversification, active portfolio management, managing currency risks and the impact of interest rates.

Domestic bias

Portfolio bias is typically chosen for one of two reasons: return expectations or risk mitigation. Amid global economic uncertainties, it is understandable why investors may not want to stray too far from home.

It should be noted however, that domestic bias has been costly in the past decade. UK investors in particular have incurred a significant cost by overweighting UK equities and underweighting the US dollar.

Trustees should review their domestic allocation, particularly in a post-Brexit world, as a portfolio that diversifies across asset classes, sectors and countries is less vulnerable to the impact of significant swings in performance in a particular country or sector.

Opportunities as market shifts

The increased volatility we are witnessing, together with flat returns during the past year, makes passive investing a lot less attractive. While there are obviously risks with increased volatility, this period will also provide buying opportunities for those with an active management approach.

In this environment, active managers should be able to demonstrate value through careful stock selection and asset allocation, providing further security to pension schemes.  

Pension funds are increasingly focusing on matching expected future liabilities and less on just capital accumulation. Alternative strategies such as real estate, private debt and private market investments can be an attractive option for schemes looking for alternative liability matching, long-term income streams.

Careful stock selection combined with active currency hedging could prove an eminently worthwhile strategy.

Strategic currency hedging

When comparing equity and currency returns, it is clear that currency movements account for a major element of equity returns in an international portfolio.

Schemes have recognised that hedging needs to become a natural element in equities investing, as it is in fixed income investing presently.

Given the increasing influence of currency movements on equity returns and considerable sterling weakness in light of Brexit uncertainty, trustees who are yet to implement an explicit hedging policy should consider doing so to avoid being hit by sudden currency movements.  

Low interest rates

Low interest rates as a result of the financial crisis have had a significant impact on UK defined benefit pension funding levels. We anticipate real interest rates to stay very low to negative over the next 24 months, with inflation expectations remaining anchored.

Given the continued low interest rate environment, pension schemes can mitigate against equity market risk by diversifying their growth assets. Another option available to trustees is hedging interest rate risk by investing in assets whose value moves in the same way as the liabilities. We have seen increased allocation in liability-driven investments and we expect this to continue in the medium term.

It is clear that a number of considerations need to be taken into account to ensure pension schemes are protected and able to alleviate any big losses in volatile markets.

An active approach to investing, a well-diversified portfolio and a hedging strategy against currency and interest rate risks should allow schemes to weather potential market uncertainty over the coming years.

Shamik Dhar is chief economist at BNY Mellon Investment Management