Pension funds are now working in an investment environment that is not only difficult but that has not been seen some time, as George Inderst reports
From the US sub-prime troubles to the global credit crunch, from the financial crisis to the economic slowdown: official economic statistics are confirming the spreading of recessionary conditions across businesses and countries. World trade growth is running much slower than the 8% level seen during the period 2004-06. Labour markets are already being affected, led by the USA where unemployment has risen to 5.7%.
At the same time, volatile food and energy prices have pushed inflation above 4% in Europe and 5% in the USA. This makes policy responses much trickier. The US Fed is alone in reacting aggressively but even it has become stuck since April. The UK's base rate is also standing still while the ECB felt it had to lift rates to 4.25% in July.
Rate hikes are also occurring in the developing and BRIC countries are facing capacity constraints following years of boom. China's official inflation rate has risen above 7%, India's to 12% and Russia's to 15%. Consequently, emerging stock markets have finally corrected sharply in face of bad global and local news.
This stagflationary cocktail led to another substantial devaluation of the major equity markets early in the summer. The bond markets are veering between fears of recession and inflation scares. Consequently, US and euro 10-year government bond yields are on a rollercoaster, around 4% levels.
As usual, opinions are split on the medium-term outlook. In July, the IMF stuck to its relatively optimistic forecasts for world economic growth of 4.1% in 2008 and 3.9% in 2009. This compares to around 5% in recent years. However, many private sector economists are more cautious. The OECD Leading Indicator is still falling sharply.
The optimists take comfort from the ongoing consolidation in the financial sector and tentative signs of a bottoming in US real estate. Furthermore, inflation may turn out to be beneficial as the global slowdown tempers natural resource prices.
Many are different in the current boom and bust compared to previous ones, but structural adjustments are underway. However, the global economic cycle may still follow a pretty traditional pattern: the US leading the downturn and upturn, with the rest of the world following a few quarters behind. Financial markets in depression cheer any positive economic news, and so may the dollar.
Pension funds were not able to remain unscathed by trembling financial markets, and many had to report negative results in the first half of 2008, particularly those with high equity weightings. Lucky the ones that used the recovery years of 2003-07 to get their exposure to equity, inflation and interest risks under better control.
Sensible asset-liability-management, including moves into LDI, has paid off early for plans that cannot afford (or are not allowed) periods of substantial underfunding. However, the world has dramatically changed for many counterparties involved in LDI structures. A thorough review and update is recommended. But what about those funds that missed the boat in the good times?
Equities - what now?
Many pension funds face pressure to reduce investment risk, as always, when results are poor. But what to do with equity risk now? Stock markets have been sold off in several steps over the last 15 months and valuations look more attractive (see chart). Investors are reported to be sitting on $25trn (€16.7trn) in cash worldwide. If you can bear the risk, should you renounce the upside potential now? Whatever ‘strategic' decision trustees are taking, they cannot fudge the question of timing the implementation.
What inflation protection?
Inflation has become the big theme for many pension plans, whether the inflation-link of benefits is conditional (as for most Dutch plans), or unconditional (a legal requirement as in the UK). Is there clarity about the impact of higher inflation on your pension plan's assets and liabilities? Do members of DC plans understand the inflation risk?
There appears considerable confusion about how best to protect against inflation. Index-linked bonds, equities, commodities, real estate, infrastructure are all said to have inflation-protection features, not to speak about inflation-swaps and other specifically structured products. However, what exactly is meant by ‘protection'? What time horizons do they cover? Is the protection dependent on a particular economic or financial scenario? Are the instruments available in the volumes required? What is the price of protection? Many questions, and the answers require more study and work. At least, by now, the discussion cannot be cut short by an interjection like ‘inflation is dead!'
Tactical asset allocation - a distraction?
Tactical asset allocation (TAA) has again become fashionable with pension funds. This may not be much of a surprise given the recent years of turbulent asset prices, and the appearance of some obvious market excesses, at least in hindsight.
Historically, pension plans never had a particularly easy relationship with TAA. It became widely discredited because of poor performance in the 1990s. Old-style TAA effectively came down to market timing, that is, moving money in and out of equities into cash and bonds. However, in a bull market, there is little to gain from being out of the market for very long. Therefore, many pension funds abstained from TAA and they also told their fund managers to concentrate on security selection.
Since 2000, investment managers have responded by offering more sophisticated asset allocation overlay strategies to pension funds, and, increasingly, also standalone global tactical asset allocation products (GTAA). The ‘global' element in GTAA is hardly new, at least not in Europe. What has changed, however, is the size of the investment universe (indices, currencies, commodities), the range of derivative instruments (for example, index futures and options) and investment techniques like new quant models for value and momentum.
GTAA managers claim they can add value on different fronts by exploiting the misvalution of markets, behavioural excesses, local market distortions or the actions of non-profit driven agents on the markets. Consultants add that GTAA may offer a source of uncorrelated alpha, and help diversify pension fund investments.
According to Mercer's 2008 asset allocation survey, 3.4% of pension plans on the European continent and 5.7% in the UK already use GTAA, typically allocating 3-5% of assets. However, experience has been mixed, and new questions are being raised.
Academically, it remains controversial to what extent any such market inefficiencies exist, and if so, whether they can be exploited profitably for long, particularly net of fees. Unfortunately, the history of new-style GTAA strategies is still short, and performance and risk data not very transparent. In addition, as investors learnt the hard way over the last year, correlations can change very quickly. In common with macro hedge funds, GTAA managers often do similar things at the same time, so substantial money can be lost when markets turn around.
Finding alpha in GTAA products may be a luxury worth pursuing for pension funds with the necessary risk budgets and governance resources. However, for a large number of pension plans there still seems to be a need to prioritise (dynamic) asset allocation for the medium and longer term.
How to find and manage the appropriate mix of beta exposures, in particular to the main risk and return factors such as equities, interest rates, inflation and credit?
Georg Inderst is an independent consultant based in London