In this week's Informed Comment, Morgan Stanley's Joe McDonnell looks at the downsides of a binary growth v matching approach to derisking your scheme's investments, and suggests an alternative.
Such an investment strategy seeks to rotate from a growth portfolio (equities) to a liability-matching portfolio (fixed income) based on one of two methodologies.
Derisking triggers
It is estimated around half of European pension funds set derisking strategies on a predetermined switching-over time, or on asset allocation changes based on funding level trigger points.
Biography
• Joe joined Morgan Stanley in 2008 from Shell International, where he was senior investment manager for pensions.
• Previously, he was head of fixed income at IBM Retirement Funds EMEA. He graduated with an MA in economics and finance from the University of Sheffield.
• He is a trustee director of the Morgan Stanley Pension Fund and a chartered financial analyst.
While this approach provides some level of clarity around future plans, the attractiveness of the entry and exit points are not considered. This could result in ill-timed switches from equities to fixed income.
For example, global equities are currently priced at their highest level relative to earnings in the past four years and potentially offer a good selling opportunity.
However, gilt yields are hovering marginally above their 20-year low and monetary policy is expected to limit medium-term prospects.
Active derisking
In an attempt to avoid the potential valuation pitfalls of triggers, the remaining derisking strategies mostly rely on systematic or discretionary market-based decisions, referencing interest rates or inflation.
While this approach considers valuations, the dimensions of derisking are still relatively two dimensional: growth versus matching.
In our experience, such narrow timing between equities and fixed income is challenging and introduces significant active management risk into investment portfolios.
As a result, the challenge for pension funds is to manage the appropriate reduction of risk without compromising expected returns by making switches that represent poor value or introducing uncertainty through market timing decisions.
In our view, investors should consider the use of alternative asset classes to facilitate derisking without the opportunity costs associated with more traditional methods.
By incorporating additional assets, it is possible to be more nuanced in managing growth versus matching, reducing the risk of being on the wrong side of a potentially binary decision.
Such narrow timing between equities and fixed income is challenging and introduces significant active management risk
There are two alternative opportunities: private market yield strategies and absolute return.
First, given their cash flow profiles, pension funds should consider private market yield strategies that have medium illiquidity, attractive yield, minimal J-curve impact and structural sources of return. Examples of these strategies include direct lending, structured credit opportunities such as bank capital release, leasing and royalties.
These private market yield strategies are expected to include stable distributions and can be implemented such that the expected cash flows are appropriate for the liability profile of a pension fund, but without material interest rate sensitivity.
Second, we advocate the use of absolute return-focused investments as a replacement for market exposure as funding levels improve. This provides the ability to skew the portfolio towards strategies that emphasise downside risk management or very low sensitivity to the general direction of market returns.
Simply adding these tools to the investment toolbox provides significantly more flexibility in targeting the correct risk-return profile for each stage of derisking specific to a particular fund’s situation. For example:
Modest funding levels – material equity allocations help drive the growth portfolio, but private market yield is preferred to public market fixed income.
Full funding – equity allocations are reduced but absolute return and private market yield strategies are used to maintain growth while lowering expected risk.
High funding levels – equity risk is removed and explicit hedging increased. Absolute return is maintained, but commitments to private markets are discontinued and portfolio liquidity is maintained consistent with obligations.
As we enter a period of increasing interest rates and full valuations across traditional markets, investors should extend their definition of derisking by considering alternative investments to improve management of the value trade-off associated with the current derisking consensus.
Joe McDonnell is head of Morgan Stanley Alternative Investment Partners' portfolio solutions group in EMEA
