Knowledge of the impacts of daily moves has helped trustees stay sure-footed through the challenges of the year to date, says David Curtis.
The experience of 2020 so far has redefined the meaning of probable - even possible - scenarios in markets. Whipsawing their way through the first quarter, and then the second quarter, markets now seem perilously priced for recovery, with aggregate valuations largely ignoring the likely duration and depth of Covid-19's economic impacts amid continued virus outbreaks.
Trustees meeting at the end of March, a week after the equity market trough, faced a bleak outlook following the sharpest market decline in history. Now, into the midsummer period, markets have staged a remarkable recovery, supported by an unprecedented central bank policy response.
Given the pace of change, decisions to reduce risk implemented at the end of Q1, on the basis of March's mayhem, were taken at a significant cost. At this point, trustees with limited oversight of day-to-day developments, and the potential portfolio impacts of major shifts in the crisis response, took serious missteps.
Portfolio construction, risk management and nimble implementation have been crucial to serving members' interests through this period - enabling schemes to thoughtfully consider their position and then capture opportunities as they arose, while avoiding the risks of decisions lagging developments. By remaining agile around rebalancing decisions, cash management and hedging, schemes have been better able to respond to material market deviations and, by limiting the pain across portfolios, outperform.
Taking the sting out of tail risks
Ahead of the crisis, schemes with strong governance in place, namely access to investment insights and the resourcing to be nimble, took the opportunity to review their strategic asset allocation, acknowledging the maturity of the economic cycle after a sustained period of reward for a "risk-on" posture. The reduction of exposures to asset classes with more "tail risk" such as high yield, emerging market debt and equity and small cap equities, in favour of core assets such as developed market equities and investment-grade credit, helped prepare schemes for the exogenous shock when it came.
Now, given that central bank policy responses to date seem to have favoured credit over shareholders, a continued focus on higher-quality investment-grade credit opportunities is providing schemes with exposure to companies with strong balance sheets, which are better equipped to withstand a more prolonged downturn and slower recovery.
Bridging the gap risks
Before global central banks stepped in, liquidity was the defining issue of the crisis, demanding careful management of liquidity and "gap risk", namely, the risk that asset prices fall significantly over a short period due to news or other drivers. The combination of increased risks and higher than normal trading costs will have forced some schemes to be forced sellers of assets to meet ongoing benefit payments.
Prioritising cash buffers or regular income generation has been critical to supporting portfolio rebalancing, and the ability to reduce exposure to higher risk return seeking assets in favour of higher quality and defensive allocations.
Tail risk hedging strategies have been an efficient tool for navigating the rapidly changing backdrop. For example, the adoption of a macro-tail hedging strategy based on options exposures in US treasury interest rates yielded two profit-taking opportunities - first, as interest rates fell and second, following the Federal Reserve's emergency rates cut to zero. This type of overlay can punch well above its weight in terms of total portfolio impact relative to capital allocation.
Taking decisions on liability hedges
With unprecedented central bank action and interest rates globally approaching their lower bounds, and in light of an extended low interest rate outlook, management of liability hedges will have been a key priority for many schemes. Following market volatility, hedge ratios may well have drifted higher than their targets; given ongoing volatility and negative sentiment, combined with higher than typical transaction costs, choosing to maintain higher hedged positions going into April would have paid off. For schemes in the midst of strategic hedge increases, phased increases - with regard to day to day developments - will have helped schemes take advantage of short-term opportunities.
Having the option to be opportunistic
As markets and fixed income, in particular, have repriced significantly, opportunistic investments have emerged in distressed debt and securitised credit. Depressed valuations and corporate capital requirements have also opened up the opportunity set in private markets, benefitting those schemes with the ability to accelerate commitments.
Through the ongoing volatility, other attractive tactical opportunities have included short oil positions, sovereign credit default swap positions, systematic tilts designed to tactically hedge against equity market downside, alongside a range of positions across the S&P 500 to capture the rebound and heightened implied volatility in options markets.
As the road through the recovery continues, trustees will inevitably face some difficult decisions and risk-return trade-offs. Empowered by information and oversight of what is happening in scheme portfolios day-to-day, trustees are able to focus on strategic decision-making based on clear objectives and future scenarios, with the flexibility to adjust their course as the route demands.
David Curtis is head of UK & Ireland institutional business at Goldman Sachs Asset Management
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