Stephan Meschenmoser, director of BlackRock's Multi-Asset Client Solutions group, outlines three ways pension funds can protect portfolios from extreme market events.
Despite ongoing concerns about sovereign debt, the gloomy global economic outlook and bank funding levels, many institutional portfolios remain significantly exposed to extreme market falls. While every investor has specific circumstances, liabilities and objectives, there are several relatively simple steps that can be taken to protect portfolios.
The first, and most conventional, is to address strategic asset allocation and determine if the total level of risk at overall portfolio level is appropriate. The temptation to lower portfolio risk should be countered, however, with the obvious but necessary reminder that this is likely to reduce the expected potential for return. Shifting to a more conservative asset allocation is not without its pitfalls.
Investors wanting to adopt a 'pure' downside protection strategy that doesn't alter the strategic asset allocation have several options available to them. In theory, the possibilities are endless. However, these can be divided broadly into derivative-based, dynamic trading and signal-based strategies, with each having different associated costs, levels of precision or certainty achievable. As with every decision faced by a pension fund investor, there are considerations to be factored into each strategy.
Derivative-based strategies use financial instruments to hedge market risk within a portfolio. They can provide investors with 'hard floors' for certain assets, giving more control over potential fund volatility. However, these strategies do tend to be more expensive, and this can evidently affect the investors' preferred approach.
Dynamic strategies seek to replicate derivative techniques cost-effectively using liquid instruments by dynamically allocating between risky and risk-free assets. These strategies usually work well in liquid markets, although effective implementation of trades can prove difficult in very turbulent markets - in other words, when protection is needed most.
Signal-based strategies do not seek to protect specific floors but rather aspire to de-risk the portfolio by predicting future market scenarios to adjust a portfolio's asset allocation proactively. Sometimes, systemic signals, often generated by sentiment indices, are differentiated from qualitative signals - for example, the insights of active portfolio managers. Both sets of signals tend to be processed in dynamic asset allocation models, which seek to provide (extreme) downside protection. Signal-based strategies are least expensive, but might entail opportunity costs - for instance, if a signal misfires and triggers derisking, causing the portfolio to forego returns.
Many pension funds face considerable funding pressures and have increasingly complex investment strategies. At the same time, the likelihood of more extreme market events occurring has increased, and the question is when, not if, they will happen. For most institutional investors, the impact these market events will have on their portfolios, and funding ratios, could be considerable. Protecting portfolios from tail risk involves costs and sacrificing some upside potential. A wide spectrum of strategies is available, and identifying and implementing an appropriate downside protection strategy is a complex task. As with all pension fund decision-making, the appropriate choices can only be made by careful discussion. No solution will offer 100% protection, but there is no reason why pension fund investors can't develop a customised protection strategy that meets their specific needs.
Stephan Meschenmoser is director BlackRock's Multi-Asset Client Solutions group.