Why trustees should prepare for a shock to the system

Stocks promptly sold off on her comments but recovered swiftly, suggesting investors were not quite ready to take her word for it.

Were they right to ignore her warning? Valuations are indeed looking stretched, potentially setting off warning bells for long-term investors.  

But we know that stocks can stay overvalued for a while: on their own, valuations tell you little about short-term timing.  

A sudden, large drop in the markets would likely rely on an unforeseen trigger that would tip the equity market over the edge.

Whichever way you look at it, forecasting the short-term future is a mug’s game. What we can say is that looking at the most sensible frameworks for assessing expected returns over five, eight or 10 years, the picture is not looking positive.

In the medium term, the future is looking dull for most major asset classes.

Forewarned is forearmed; starting to build up cash holdings now – and grinning and bearing the zero per cent pension funds will earn on it – could set trustees in good stead for a liquidity shock

We could see a steady stream of low returns, or there could be periods of great returns and crashes, but in general it currently looks like common risky assets are priced for low returns.

The good news for pension funds is their long-term investment horizon. While they can’t predict what will happen to the markets, they can make sensible preparations for what the future may bring, and ask the question: if equities, bonds, cash and property are all structured for low returns, what else can we do?

Prepare for a shock

The people who make the markets now are different from those 20 or even 10 years ago.

In those days the major players were the professional market makers; today they are, generally speaking, the high-frequency traders: companies that don’t have huge piles of committed capital.

These players are to some extent an unknown quantity: they haven’t yet been tested over many cycles and, because of this, our understanding of how markets will behave under adverse conditions is limited.

We could, therefore, see some interesting surprises around liquidity in the not too distant future.

Pension funds should be lucky – their inflows and outflows are usually more predictable than for, say, retail mutual funds, so they do not need to be particularly liquid.

Trustees could do worse than to start thinking about this sort of scenario and asking what they can do, not only to seek to reduce downside risk for members, but also to benefit from such a situation.

Forewarned is forearmed; starting to build up cash holdings now – and grinning and bearing the zero per cent pension funds will earn on it – could set trustees in good stead for a liquidity shock, should it arise.

Consider the alternatives

Another option is to take a look at alternative investments.

Data published by Towers Watson in its global alternatives survey 2014 shows that assets under management hit $5.7tn (£3.73tn) last year, and pension fund assets represent 33 per cent of this money.

Alternative assets offer valuable diversification that can provide reassurance in times of volatility, and for pension funds in particular this can be an appealing proposition.

It is important, however, to consider these investments with eyes wide open: be aware of the limits to your own knowledge and work with someone who understands the assets well.

Get active

When looking at medium-term expected returns we are talking about passive returns. If you can identify an active manager with the potential to deliver added value over the medium term, now could be a good time to do so.

The difficulty of identifying such a manager has been widely publicised. But if we are destined for a sustained period of low average returns, it could be worth starting to think creatively.

James Clunie is manager of the Jupiter Absolute Return Fund