How to weather market turmoil

Investors have been on a big roller coaster in recent months. Market volatility has increased, in some segments dramatically. The main driving element was the bad news from the US mortgage business. Contrary to earlier hopes, the sub-prime crisis, already rumbling on for many months, could not be contained.

The contagion of the money, credit and other markets hit the financial sector particularly badly. Banks and other financial institutions trust each other less than before and this generates solvency problems for some. Central banks try to prevent systemic effects with liquidity injections. Consequently, interest rate expectations have significantly changed.

It has to been seen how strongly financial troubles spill over into the real economy. The world economy is still growing at a strong rate of over 5% real per annum with China steaming ahead even faster according to official figures. Strategists have also changed their minds several times at short notice about the investment environment we are in. The consensus opinion about the medium-term outlook has changed from a ‘goldilocks-world' to an ‘inflation-fears' scenario in spring and a recession threat scenario in summer.

Pension plans are, of course, not immune to the rapid changes in financial conditions. The immediate task is to remain in control over the impact on investments most directly exposed such as ABS, property and financial stocks, and certain specialist funds. Some pension funds have reacted with changes in their tactical asset allocation while the majority probably hopes to see the worst storms go by.

 

Most pension funds have had little time yet to work out what the implications are for their medium and long-term investment strategy. Despite, or because of, the high degree of uncertainty, it is time for pension boards and investment committees to look beyond short-term events in their coming meetings. There are a number of important points to discuss with the specialists.

Assets: Big market gyrations often bring interesting things to light. "I did not know we owned these assets" is a typical trustee reaction.

Big market gyrations often bring interesting things to light. "I did not know we owned these assets" is a typical trustee reaction.

Fund managers: Are there major surprises in the performance, and why? How has their outlook changed? Does the crisis open new longer-term investment opportunities for the pension fund?

Are there major surprises in the performance, and why? How has their outlook changed? Does the crisis open new longer-term investment opportunities for the pension fund?

Benchmarks: The weight of the financial sector in mainstream indices had strongly increased in recent years. Again, how could pension funds best avoid piling into overvalued sectors?

The weight of the financial sector in mainstream indices had strongly increased in recent years. Again, how could pension funds best avoid piling into overvalued sectors?

Credit risk: After a long period of complacency, markets now discriminate much more between good and bad credits. Many pension funds have diversified their bond portfolios into lower credit ranges in recent years, often for very low risk spreads. How are your corporate, high yield and emerging bond portfolios holding up? Are there opportunities to enter certain segments on a longer-term perspective?

After a long period of complacency, markets now discriminate much more between good and bad credits. Many pension funds have diversified their bond portfolios into lower credit ranges in recent years, often for very low risk spreads. How are your corporate, high yield and emerging bond portfolios holding up? Are there opportunities to enter certain segments on a longer-term perspective?

Liquidity risk: Pension funds normally do not have massive short-term liquidity requirements but there are exceptions. For example, those in the middle of a major restructuring process may be affected. More likely, some of their agents may face liquidity problems, for example in the private equity or hedge fund zone.

Pension funds normally do not have massive short-term liquidity requirements but there are exceptions. For example, those in the middle of a major restructuring process may be affected. More likely, some of their agents may face liquidity problems, for example in the private equity or hedge fund zone.

Counterparty risk: The situation of investment banks and other financial institution you are dealing with can change overnight. How strong is the process of managing counterparty risk, for example in the derivatives area, where many pension funds have little experience?

The situation of investment banks and other financial institution you are dealing with can change overnight. How strong is the process of managing counterparty risk, for example in the derivatives area, where many pension funds have little experience?

Funding position: Interest rates are swinging around but the effect differs across countries as different discount rates are used for measuring pension liabilities. It is advisable to receive an update on the funding position of the pension fund, and how it developed.

Interest rates are swinging around but the effect differs across countries as different discount rates are used for measuring pension liabilities. It is advisable to receive an update on the funding position of the pension fund, and how it developed.

 

Market turmoil is a real life test for all the diversification efforts. Many investment specialists are surprised by how correlations in the markets have changed in recent months. A number of sophisticated investment strategies have been thrown out of the orbit by ‘one in 100,000 years' type of events.

In fact, the history of diversification by institutional investors has not always been a happy one. The diversification across stock market sectors was often less risk reducing than envisaged. Then people thought international diversification of bonds and equities would do the trick, only to see correlations go up in critical times. Even using fund managers with different investment styles often does little in terms of spreading risk.

Diversification across asset classes has been the latest trend in the pensions industry. The expectation is that commodities, real estate or currency for example would show little or even negative correlation with mainstream equities and bonds.

However, in recent months some correlations have turned out to be dramatically different from the ones used by managers in their presentations or even by consultants and actuaries in their ALM studies.

Pension trustees will ask questions. The whole idea of diversification is not to have "all eggs in one basket" but in times of crises, you seem to have fewer baskets than you thought you have.

This is not to argue against greater asset class diversification per se but to warn against overly relying on past correlations statistics. In particular, such statistics are not given by exogenous physical laws but are themselves the result of investors' behaviour. In particular, correlations shoot up when too many people try to do the same thing at the same time (or are forced to do so).

Market mania and panics are, however, not necessarily a matter of psychology. Rationally built quantitative models suffer the same fate, and even contribute to rising correlations, as they seem to build on similar buying and selling signals.

It can be argued that such co-movements would be less dramatic for longer-term strategies typical for pension funds as they can sit through such times of turbulence. However, there is no guarantee that long-term correlations between asset classes could not alter substantially as well. After all, in recent years, the prices of so many asset classes were driven up simultaneously by the excessive liquidity provided by central banks.

The jury is out about how well the newly sought asset class diversification will be working out for pension funds over a period of five, 10 or 20 years. On a positive note, a greater number of pension funds now have real life experiences with asset class correlations than in the past and the chance to scrutinise that experience in some detail.

Georg Inderst is an independent consultant based in London.
(georg@georginderst.com)