Keeping a bead on a fuzzy target
This year started the same way as the old year ended - in confident mood. Most forecasters draw a benign picture for the world economy and capital markets over the next few quarters. However, the experts agree much less on the medium-term outlook.
Optimists versus pessimists
The optimists basically see a continuation of the benevolent environment experienced in recent years, ie, strong world economic growth combined with moderate inflation. Medium to long-term bond interest rates, relatively stable in the region of 4-5% in the main currencies (Japan remains the exception), do not point to a major change of direction. The growth of corporate profits may slow down somewhat after four years of double-digit growth but stock market valuations do not appear stretched. Certain market excesses are inevitable but they are isolated (eg to some single markets or funds), self-correcting, and nowhere near the hype experienced in the late 1990s.
The camp of the pessimists sees
risks looming in several corners. One view is that the central banks have been too slow to raise interest rates and there is still a massive liquidity overhang in the markets. Most asset prices have shot up too high already. Inflationary pressures are becoming more widespread, including the labour markets.
Cheap imports from China (and elsewhere) have contributed to the ‘disinflationary boom’ but now we are left with massive global imbalances (eg, the US trade deficit and the increasing piles of
currency reserves in emerging markets). The high degree of leverage makes financial markets vulnerable to any unexpected event.
The future may not turn as black or white as the two scenarios suggest. Nonetheless, it could be useful for trustees and officers to hear the views of their investment experts on the medium to longer-term scenario. Pension funds have now enjoyed three to four years of more or less strong returns from their assets, and this potentially leads to complacency.
Structural changes in markets
This is not only an issue for tactical and dynamic asset allocation but also for strategic asset allocation. Many pension plans are in the process of a major restructuring exercise, driven in particular by the aim to lower volatility (through better diversification), enhance returns (through investment in promising alternative assets) and reduce risk (of mismatch against liabilities).
The review of strategic asset allocation is not an experiment in a vacuum. It is important, therefore, that pension plan directors get a good feel for major structural changes in the market environment. Some of the burning questions are:
o Alternative players. Private equity and hedge funds are playing an increasing role in capital markets. Trustees hear about record levels for M&A activity, rising gearing levels and valuations. How will this affect the future returns of those funds? Moreover, what is the effect on other assets classes, eg, public equity, corporate bonds, currencies and so on?
o Expensive diversification. A number of pension funds are reducing their mainstream equity allocations and increasing buyout equity. Are the cynics right that they are effectively buying the same assets back at a higher price and in a more risky package?
o Falling spreads. Investors are chasing every source of additional return. There have been enormous changes in the credit markets, including a long list of new derivative instruments. At the same time, taking on credit risk is being compensated less and less. How exposed is your fund to any setback?
o Capital flows. Emerging equity markets have again reached the peaks. Emerging bond spreads reached new lows in February (eg, the JP Morgan EMBI+ at 165 basis points). Many specialists emphasise the improving fundamentals in the developing countries. However, will concerns return over fickle capital flows, wobbly commodity prices and local politicians with incompatible agendas?
The rules of the asset allocation game are affected by ‘regime shifts’. Historic risk/return figures may not mean a lot, particularly with alternative asset classes where the history is short in the first place. When trustees chase higher returns they are now likely to encounter high valuations. This adds a tricky timing dimension to any decision to rearrange strategic asset allocation.
When pension funds seek broader diversification, they may also get less than they are hoping for. Big money
is chasing the same ‘diversifying’ assets that are often small and not
so liquid. This is likely to affect the (low) correlations between asset classes seen in the past.
The risk-reducing effect may be much less than expected, even more so in case of market turmoil when it is most needed. In short, it is easy to argue for wider asset class diversification in general but things become less clear-cut when looking at alternative assets one by one, and now.
Finally, even defensive measures are heavily influenced by the ‘when?’ and ‘at what price?’. A good example is the introduction of a liability-driven investment strategy (LDI) in order to stabilise the funding risk.
Many trustees like the idea in principle but find little guidance about when and how exactly they should do anything about it. Again, the actual market environment at the time of implementation (in particular the interest rate curve) is decisive.
How to implement LDI?
Despite the controversies over LDI, a number of pension funds have decided to move into some sort liability-based investment strategy. Their problem is rather ‘what approach to take for LDI, and how to implement it?’ There are a surprising number of decisions to be made for pension plan directors, so it is worth having a good workshop around the main issues.
Looking at the developments in the last one to two years, the variety of approaches taken by various pension funds is striking. This should not be too surprising, given that people mean such different things when they use the term LDI. Another reason is the different institutional and financial environment of pension plans across countries. This includes key factors such as the different solvency regulations, the strength of the sponsors’ covenant and the actual funding position.
LDI in the narrow definition, ie, an exact ‘cash-flow-matching’ portfolio, is hardly practical or affordable for most pension plans. Therefore, other ‘immunisation’ strategies are required to mitigate the typical main risks - interest rate, inflation and longevity risk. There are three main avenues taken by pension funds:
Bonds. The first route is to change your underlying asset allocation to reduce unrewarded mismatch risk. To mitigate the interest rate risk, a number of pension funds are currently extending the duration of bonds (and often also increasing their weighting).
The first route is to change your underlying asset allocation to reduce unrewarded mismatch risk. To mitigate the interest rate risk, a number of pension funds are currently extending the duration of bonds (and often also increasing their weighting).
In a similar way, a better hedge of inflation risks is sought through the addition of inflation-linked bonds. ‘Longevity bonds’ would be the logical third element in the management of the trinity of key risks, but they are not (yet?) available on the financial markets.
Swaps. These days, LDI increasingly makes use of derivatives, as their availability and liquidity has enormously improved. Better cash flow matching and/or duration management can be achieved with the help of interest rate swaps. Inflation swaps are useful when future pension payments are inflation-linked. Therefore, a swap overlay has become popular as a second route in LDI.
These days, LDI increasingly makes use of derivatives, as their availability and liquidity has enormously improved. Better cash flow matching and/or duration management can be achieved with the help of interest rate swaps. Inflation swaps are useful when future pension payments are inflation-linked. Therefore, a swap overlay has become popular as a second route in LDI.
Funds. A third major route is now offered by fund managers in the form of LDI funds of some sort. Such pooled products may consist, for example, of a series of ‘duration buckets’ or sub-funds of pooled swaps of different maturities. Pension funds may mix them in order to approximate their own cash-flow requirements.
A third major route is now offered by fund managers in the form of LDI funds of some sort. Such pooled products may consist, for example, of a series of ‘duration buckets’ or sub-funds of pooled swaps of different maturities. Pension funds may mix them in order to approximate their own cash-flow requirements.
The three approaches can be combined and varied in many ways. Pension plans in several countries have to deal with additional guarantees, floors and caps, triggers, recovery periods and similar regulatory constraints. Therefore, some providers offer even more sophisticated programmes, including options, swaptions and futures.
LDI allows a clearer management of certain risks, but also introduces new costs and uncertainties (eg, counterparty risk). Key decisions to be made include:
o Full or partial matching (eg, of a pensioners sub-fund only);
o Direct (dealing with derivatives) or indirect (eg, swap overlay managed by an asset manager);
o Segregated or pooled solution (more likely for smaller funds);
o ‘LDI plus x%’ products seeking additional returns (at some additional risk);
o Leveraged LDI funds (to free capital, eg, for equity futures); and
o Timing (immediate or phasing in over time).
Pension liabilities are not a fixed number but a fuzzy target, moving all the time. If they are the new ‘benchmark’, how do you nail it down with your fund manager? Some people prefer absolute benchmarks like inflation plus x% or LIBOR plus x%. More complex proxies are proposed, eg, a mix of fixed interest and inflation-linked indices of various maturities.
In practice, some simple questions are not always clearly answered. What is ‘success’ in LDI? And how are the fund managers and investment banks involved best incentivised? Whose responsibility is the ‘mismatch’ between the LDI strategy and the real liabilities in future?
Georg Inderst is an independent consultant based in London.