The divergence in performance between asset classes over the first half of 2022 has been extreme
The change in course from the Federal Reserve and other central banks, signaling the possibility of sustained rate increases, has driven the returns from different assets classes in different ways. A long period of stable equity, bond and private asset returns may now be over.
As shown in the chart below, the notable outperformer over the last few years, including H1 2022, has been private equity (and private assets more broadly).
There is a significant time delay in industry-level private equity returns being available but our pension fund clients tell us they are assuming a return of approximately -10% private equity assets over for H1 2022, and this is the return we will assume for the subsequent analysis.
Despite the fall in risky asset prices over H1 2022, from the perspective of defined benefit pension funds, the fall in bonds – and therefore in the present value of liabilities – has been larger. This has generally led to an improvement in pension funding ratios.
In addition, the divergent performance of different asset classes – most notably the outperformance of private assets on a mark-to-market basis – has led to changes in the asset class weights and exposures within pension funds.
Private assets now have larger allocations relative to equities and bonds. For example, consider a model pension fund with asset class weights at the start of 2021 as shown in the table below. Given the evolution in asset prices, by the middle of 2022 its actual weightings have shifted significantly with the private asset allocation increasing materially.
Pension funds would be expected to rebalance by selling private assets and buying bonds, as well as equities in many cases. However, private assets are illiquid, and funds would face significant cost to reduce private exposure via secondary sales. Economically, this is not an attractive option.
More significantly, because of the rapid improvement in funding levels over the past 18 months, many pensions should be looking to lock in these gains by reducing exposure to risky assets and increasing the size of liability hedging programs. This approach, known as the “glide path”, reduces the risk of a sudden deterioration in funding levels if markets subsequently fall.
The glide path approach is important from a risk management perspective but now faces challenges. Conventional wisdom says the pension should sell privates to 1) buy bonds, 2) increase allocations to LDI programs (buying liability hedging swaps requires cash to support the initial margin of the required derivatives), and 3) increase exposures to low-risk alternatives such as some types of hedge fund.
But the difficulty of selling its outperforming private assets leaves the fund facing significant risks: should equity markets fall or long-dated interest rates decline – or both – it will have missed its opportunity to secure its improved funding ratio.
In the short term, the list of possible solutions is limited. Despite its improved funding ratio, the model pension fund has a liquidity problem. There are three main options:
- It could change its strategic asset allocation targets to match its current allocations more closely and thereby release some of the cash required for the glide path approach.
- It could swap a portion of its physical equity or bond holdings into synthetic exposure that has lower margin requirements, again freeing cash that it can use to better match its liabilities. Although the second approach is relatively standard for larger schemes, it cannot be implemented quickly if it is not already in use.
- The pension fund could decide not to hedge its liabilities or to not de-risk as its funding ratio improves. Many pension funds will unfortunately be forced to take this course and in doing so will fail to lock in the hard-won gains in their funding ratio over recent years.
In view of this setback, pension funds should consider complementing illiquid private assets with defensive strategies designed to produce liquidity when needed. Tail hedging and trend following strategies produce liquidity in market drawdowns, typically the points at which rebalancing is required.
They also complement each other well (tail hedging tends to perform well in sudden falls and trend strategies in more gradual declines).
In one sense, investing in private assets represents a decision to sell optionality: you give up future flexibility to manage allocations and access your funds, in exchange for the expectation of improved performance.
Tail hedging-type strategies are a way to buy back that optionality, manage your illiquidity risk and provide flexibility and agility in a crisis. Perhaps the current episode will act as a reminder that the risks of unprotected illiquidity are significant, and that the realization of those risks can have very significant portfolio consequences such as we are observing now.
[i] https://pitchbook.com ; https://www.cambridgeassociates.com/wp-content/uploads/2022/04/WEB-2021-Q3-Real-Estate-Benchmark-Book.pdf; https://www.cambridgeassociates.com/wp-content/uploads/2022/06/Prelim-Template_Real-Estate-Q1-2022.pdf