The financial setbacks of recent years have left many pension funds in a difficult position. With their concentration in equities, portfolios were damaged by the collapse of the technology bubble, while the simultaneous fall in bond yields raised pension liabilities. Additionally, government reviews and legislative changes have all placed pension schemes under tremendous pressure.
Going forward, pension fund investment decisions are likely to be dominated by the need to select an asset mix that can generate strong real returns while matching future real liabilities.
In this article we examine the relative merits of different assets, their historical performance, how they perform as a hedge against inflation and what the implications are for pension fund investment strategies.
The importance of diversification was emphasised in the seminal work by Markowitz in 1952. Markowitz suggested that by combining assets that are weakly correlated, it is possible to lower portfolio risk, without necessarily damaging the expected return.
Consequently, it is sensible to begin our analysis by examining correlations between assets. In the UK and Europe, pension fund allocation is dominated by equities and bonds; the average split being 60-70% in equities, 20-30% in government bonds, with the rest of the portfolio distributed across cash and alternatives. Thus, it is important to begin our analysis by looking at the historic performance of, and correlations between, equities and bonds.
The relationship between bonds and equities has been unstable over the past two decades. Theory suggests that they should be positively correlated. Cash flow valuation techniques use the bond yield as a discount rate for the future stream of earnings on equities. As a result, equity and bond returns should move together under normal circumstances.
Examining the performance of UK and German equity and bond markets over the past 25 years, we find that the evidence provides some support for the theory. The annual correlation of weekly stock and bond returns has been strongly positive for most of the 1980s and 1990s. The correlation has hovered around +60% for most of the period, temporarily turning negative only in 1988, shortly after the Great Crash of October 1987. The correlation quickly returned to +60% levels and did not turn negative again until 1998 in the aftermath of the Asian financial crisis, and again in 2001 in the wake of the bursting of the technology bubble.
Where do we stand now? The correlation between equities and bonds remains negative although not at the extreme levels seen in the wake of the tech stock bubble. The current correlation between weekly returns of stocks and bonds, stands at -22% in the UK and -17% in Germany. This suggests that financial markets may still be undergoing a period of strain; however, current correlations are a vast improvement from the -80% levels seen in 2003. What are the special factors currently influencing the markets?
Firstly, long-term global real yields currently stand at historically low levels. The average real yield on UK government perpetuals over the past 250 years has been 2.8%. At the time of writing, the yield on the 50-year UK inflation-linked bond is just 1.16%.
There are a number of factors to explain the historic lows in global government bond yields. Firstly, official interest rates have been exceptionally low in developed economies. Secondly, Asian foreign exchange reserves reached extraordinary levels and have led to strong demand for government bonds in the US and Europe. The growth in foreign exchange reserves has exceeded net government bond issuance for the past two and a half years. Thirdly, the asset allocation decisions of long-term investors, such as pension funds and insurance companies, have been constrained by accounting and regulatory changes. These factors have impacted the relative valuation of equities against government bonds.
The near equivalence of equity dividend yields and bond yields in the UK suggest that financial markets are discounting unrealistically slow rates of nominal GDP growth and long run inflation. In Europe, equities are looking cheap across a number of valuation measures, price to book, dividend and earnings yields are near 20-year highs.
Going forward, real bond yields are likely to rise as inflationary pressures build globally. The key issue for investors, and in particular for pension funds with long-term real liabilities, is that of inflation protection. In order to build a portfolio which provides strong real returns, it is important to examine how each asset class performs under different inflation and growth scenarios. Our findings show that equities and commodities provide a good inflation hedge in the long run; however, shorter term, inflation-linked bonds provide the best inflation protection.
Equities have been considered to be a real asset because the investor receives dividend payments plus any capital appreciation of the stock.
However, as seen in the recent downturn following the technology bubble, they do not necessarily hedge against inflation in the short run. UK equities have produced positive real returns across different stages of the business cycle over the past 100 years. The best performance was seen in an environment of below-trend inflation, with average returns ranging between 10% and 14%. Unexpected short-term inflationary spikes, as seen in the 1970s, dealt a severe blow to equity returns, with real returns slipping to as low as -58%. Weak returns were also seen during deflationary periods, for instance -14% in 1929.
These figures highlight that equities are not necessarily a good hedge against inflation for investors with short investment horizons. Testing stock performance over longer periods reveals that in order to achieve consistent positive real returns, investors will need to hold equities for at least 23 years.
Commodities as an asset class are almost as volatile as equities; however, they do provide a strong diversification advantage. Commodities do not move in tandem with equities, and they performed well during the recession in the early 1990s, producing real annual returns as high as 29%. The true benefit of investing in commodities lies in the ability to provide an inflation hedge during periods of unexpected sharp rises in inflation. Commodities were the only asset class to post positive returns during the stagflationary 1970s. However, as in the case of equities, over the short run, commodities do not always provide a robust hedge against inflation. The minimum holding period required to ensure that commodities consistently produce positive real returns is 10 years, a far shorter period than that required by equities, in spite of possessing such high volatility.
Inflation-linked bonds provide the best short-run inflation protection. In the past they have underperformed during periods of high growth and low inflation. However, this coincides with excellent returns from commodities and equities and supports the case for including inflation-linked bonds into the portfolio to act as a diversifier.
In addition to this, inflation-linked bonds are not as risky as the other asset classes, and help to lower the overall risk of the portfolio.
Having examined the historical performance of equities and commodities, we find that although they provide protection against inflation in the long run, the higher level of short-term volatility of equities and commodities could pose some dangers for investors with short duration real liabilities.
Total returns of index-linked bonds possess a low level of volatility and a good short-term hedge against inflation. Thus, a mix of real assets should provide the investor with an optimal inflation hedge.
Sree Kochugovindan, qualitative strategy, global asset allocation with Barclays Capital in London