In light of the recent market correction and heightened volatility, Stephanie Baxter explores whether schemes should consider downside protection strategies
The recent market correction and rise in volatility have reminded us that we are still in very uncertain times. It is feared the equity rally, which has improved many pension schemes' funding levels, is coming to an end.
Should schemes have concerns, they could look to implement some form of equity downside policy to protect against a market downfall.
Of course, insurance strategies such as equity options involve paying a premium and change the return profile of equities, which may not always make sense in the current low-yield environment. However, they are looking look low cost compared to historical levels due to the long period of unusually low volatility.
But is it a good time to purchase some protection, or has that ship sailed given the recent uptick in volatility?
These strategies can cause a significant drag on overall returns even when allowing for the cushioning effect during equity drawdowns, according to Goldman Sachs Asset Management EMEA and Asia Pacific global portfolio solutions group head Shoqat Bunglawala.
"This is predominantly due to the insurance effect of investors essentially willing to overpay for protection - that's very well exhibited in equity option pricing when you look at the difference between realised and implied levels of volatility. That overpayment results in explicit protection strategies being expensive in our view."
Willis Towers Watson has had a view that one way to reduce risk is via options; however managing director Treeve Coomber says that, since the price increase following February's volatility, "perhaps it's a bit more questionable now."
However, for Legal & General Investment Management senior solutions & liability-driven investment (LDI) product specialist Femi Bart-Williams, while some structures have become a little less compelling, others have become more compelling.
He says: "Broadly, purchasing downside protection is still towards the cheap end of its historic range, albeit a bit more expensive than before the market volatility we've seen this year. Other structures, for example, collars where schemes sell away some upside to pay for downside protection, are also cheaper than they have often been historically."
Coomber explains using options is one way to reduce equity risk, either by buying puts when they hold equity, or alternatively selling equities and buying call options.
"I know one pension fund has implemented buying call options, which release capital for other things such as being able to buy bonds for interest rate and inflation hedging. It is more like a synthetic equity strategy that has other benefits," he adds.
Factors to consider
Cost is, of course, one of many factors to consider. Given the drag that can occur over the long term, it is important to bear in mind the time period over which trustees would think about deploying those sorts of strategies. Also, what level of protection is needed, the implementation path, and how to source the collateral. Sourcing collateral from an LDI portfolio is usually the most efficient, but it can also be released by synthesising physical equity, according to Bart-Williams.
Some of LGIM's clients have recently implemented structures, while others are considering their options. Innovations have included using the sale of interest rate swaptions to fund the purchase of equity downside protection, and the firm has seen increased interest in financing equity protection by selling away potential future corporate bond capital gains if credit spreads tighten further.
However, schemes should think about protection strategies in the context of their specific circumstances and funding level objectives.
Redington chief investment officer Philip Rose explains: "We evaluate the effect of any strategy on both expected return and risk over both the short and long term. Part of that evaluation would include comparing any option strategy with both systematic trading strategies in equities and reducing overall exposure to equities if that enabled schemes to meet their objectives."
These can be quite complicated strategies to think through and manage. Coomber says this quite often leads schemes to conclude that using options is really about reducing net equity exposure, and therefore it might be easier to just sell more equities and buy other assets with a different return driver.
He adds: "Pension funds are usually driven more by their strategic goals and structural needs, rather than always reacting to short-term pricing and taking a fundamental view on equity markets."
For example, a lot of schemes have been taking profits from equities and buying more long-term bonds as they hit de-risking triggers due to funding levels rising on the back of higher equity markets.
Rose adds Redington's clients which have bought options have generally done so as part of strategic asset allocation to systematic strategies, which "reduce the uncertainty over future option costs and have a quantified effect on expected returns so they can continue with the strategies over the long term".
A typical driver is when schemes are coming up to a valuation or there is a short period they need to get through. They may need 12 months to work through a longer term decision, and do not want to be caught out during that time. Also, if the sponsoring employer is a financial institution, which has to hold capital against the scheme and equity exposure might increase that capital need, it would be happy for the scheme to buy some protection, says Coomber.
Bunglawala argues if there is a concern over shorter term periods, an alternative to just focusing on equity protection could be blending a range of different macro hedging or tail risk hedging strategies:
"A blend of equity protection, some element of credit protection, potentially some exposure to safe haven currencies, like the dollar and yen, with a range of positively carrying and return strategies can help offset the cost of protection - otherwise it can end up being quite a punitive negative carry when a normal market environment that continues to move positively occurs, especially given equity protection strategies can be pretty negative yielding during those periods."
He adds a better way to seek long-term protection is to firstly ensure the overall long-term portfolio is well-diversified, and secondly, to incorporate strategies like momentum or trend-following strategies "which exhibit risk mitigation given they can short markets during drawdown periods and therefore can also perform a very effective role as a protection strategy."
HSBC Global Asset Management says it has had a lot of interest in its ‘best efforts protection policy' institutional product suite. It describes this as a balanced portfolio whereby asset allocation and expected return profile are agreed and, as a result, a maximum drawdown, normally over a set time-frame.
Senior product specialist Keith Swabey says: "Clients are looking for some sort of protection against the possibility of falling asset markets, while not wanting to pay the full price of a bank guarantee or the smaller premium of the put structure. So far, the majority of the interest has been in Continental Europe and in Asia." For example, it has recently put it in place for a German fund with DB-like benefits. The pension plan considers this as a form of protection on the asset side, while being part of an overall risk reduction policy.
There are several ways to get equity protection; schemes must consider strategies in the context of their strategic goals and not react too much to short-term pricing.
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