Diversification urged in drive to hedge risks

Defined benefit pension fund investors should diversify their portfolios into alternative assets to hedge against rising inflation and equity volatility, Morgan Stanley say.

Rising prices for risk-averse strategies such as cash, gilts and gold, mean investors should look at alternatives with lower correlation to traditional asset classes, the firm’s asset management arm said.

Morgan Stanley Alternative Investment Partners managing director Joe McDonnell said a combination of global macro, catastrophe insurance, secondary private equity markets and credit offered a better way to generate low-risk returns because they had lower correlations with inflation.

Speaking at a briefing in London, he said: “It’s not an easy market to be risk averse in. It’s more difficult than in 2008 to take risk off the table. This is a minority strategy, so 4% to 5% of capital. There is a tail risk, so portfolio construction is important.”

Statistics from Hedge Fund Research shows global macro funds offer good downside protection, with fund correlation with the S&P 500 Total Return of nearly 40% almost halving to 20% on the downside.

Catastrophe insurance can also provide good diversification, with very low correlations with global equities and bonds.

McDonnell said pension funds should look at the outcomes they want to achieve rather than a static view of asset allocation figures.

“Pension fund managers are now more interested in outcomes, there’s been a shift in mentality over the last few years,” he said.

Straight hedging against inflation also required using assets with higher levels of beta and cost efficiency, such as alternatives.

An example portfolio used by the firm to hedge inflation risk had a 14% allocation to hedge funds, 7% to macro, 15.6% to commodities and allocations to other alternatives such as catastrophe risk, infrastructure, real estate and global REITS.