John Dewey, senior strategist at BlackRock Multi-Asset Client Solutions, shows how DRV might complement pension schemes' strategic asset allocation.
The journey to full funding requires effective risk management and exploiting opportunities dynamically to enhance investment returns. Pension schemes are under pressure to respond swiftly to opportunities as they arise - something typically achieved by changing a scheme's strategic asset allocation. But many schemes are now exploring ways of dynamically switching exposure between instruments, as well as changing their strategic allocation.
Known as Dynamic Relative Value (DRV) management, the process requires the discretion to switch exposure between instruments to enhance the expected return of the portfolio within defined risk tolerances. Heightened regulation, higher costs of raising capital and supply and demand distortions all point toward a continuation of the current volatile financial environment. Pension schemes with a long-term investment horizon and a significant asset pool are well positioned to take advantage of this.
This does not mean materially changing the investor's strategic asset allocation, such as the overall interest rate and inflation exposure (hedge ratios) - these are strategic considerations to be determined in the context of the scheme's broader risk and return objectives. Instead, DRV focuses on dynamically capturing changes in relative value between the wide range of assets and derivative instruments in the risk management 'tool kit'. To facilitate this efficient and timely allocation of capital, many pension schemes have put in place flexible mandates with a centralised collateral pool.
DRV differs from active management or asset allocation views, although DRV does not preclude the use of active management alongside the process. Indeed, we expect the best results to be achieved by making full use of both management styles alongside a 'journey plan' for managing strategic asset allocation, since they seek to exploit different types of opportunity.
An investor considering a DRV approach should consider the suitability of the approach and the potential risks. These include:
• Market levels: In the DRV framework, transactions are carried out to enhance expected long-term return. However, there is no guarantee the transaction will secure the best possible market level available over a period of time.
• Basis risk: Changing the instruments used may lead to underperformance on a mark-to-market basis.
• Roll risk for synthetic instruments: Instruments such as futures, total return swaps and repurchase agreements must be rolled on an ongoing basis. There is a risk the cost of initiating a new contract at the maturity of an existing contract is higher than envisaged or a specific instrument cannot be traded due to a lack of appetite.
• Counterparty risk: Using a wider range of derivative instruments will change the investor's exposure to counterparty banks. Effective counterparty monitoring and collateralisation are vital.
• Liquidity risk: The instruments used have different liquidity characteristics and transaction costs.
While these are important considerations, DRV management can enhance investment performance in a clearly defined and transparent framework. It is most suited to pension schemes with medium to long-term goals and is most effective when managed by a central derivative and collateral manager with access to a broad range of financial instruments.
John Dewey is senior strategist at BlackRock Multi-Asset Client Solutions