KEY FACTS
- Barriers to diversification slowly dissolving
- Spreads have widened creating real opportunities in high yield and emerging market debt
- Risk management the dominant theme for pension funds
- Currency hedging has surged over the past year
There is no slowdown in the diversification story as investors look to minimise risk, and asset opportunities continue to widen. Some of the biggest barriers to diversification are slowly dissolving - emerging markets are becoming more liquid, the boom in commodities continues despite concerns over the US recession and the froth has come off the property market creating forced sellers. Investors are also continuing to move into hedge funds, and more slowly into non-cyclical investments such as environmental assets, agriculture and water.In terms of different styles of equity investing, Jens Schmitt, head of institutional business for Continental Europe at JPMorgan Asset Management, says that after a long period of quantitative investment success, correlations have slowly been going to one, encouraging investors to move out of classical equities to growth areas such as Asia and emerging markets. Small caps are a good diversifier but investors are shifting back into megacompanies which are more defensive, offer better liquidity and are on more attractive valuations. For example, the S&P is currently trading on a P/E ratio of 14 while the Russell 2000 is on 20. “In the past, investors constructed portfolios of UK bonds, equities and property and thought they had reduced risk, but they had exposure to one region only,” says Ana Cukic, co-manager of Insight’s multi-asset team.
“What really makes sense is to see how much return you can get per unit of risk, and whether if you add equities, property and other asset classes together, you can increase your return per unit of risk,” she adds.
Many investors built up their risk tools, such as value at risk, after the crisis of 2003, and will be looking to improve upon them. Based on the normal value-at-risk, modified value-at-risk is increasingly used to adjust the risk, measured by volatility alone, with the kurtosis of the distribution of returns. It therefore allows investors and asset managers to measure the risk of a portfolio that includes assets with non-normally distributed returns like hedge funds, and to design an optimal portfolio by minimising the modified value-at-risk for a given level of confidence.
“Investors are looking at modified value at risk,” says Ms Cukic, “because when you introduce derivatives, commodities, private equity and real estate, you can’t rely on standard deviation any more - the distribution won’t be normal and there will be a small chance of a big loss.”
The Year of Opportunity
In fixed income, there has been a big shift to de-risking using government bonds. “At the beginning of the year, 2008 was hailed as the Year of Stabilisation. More recently, it has been called the Year of Opportunity because spreads have widened so heavily creating real opportunities in high yield and emerging market debt, especially local currency because this adds diversification and emerging market countries are now better financed and have got rid of their deficits, so their currencies could appreciate relative to the dollar.”
The position for investors having to deal with an overhang of illiquid credit products remains difficult, however.
 | “Many investors have been left holding extremely volatile asset-backed securities that are difficult to trade,” says Nigel Jenkins, senior strategist at the global fixed income team of Payden & Rygel. “Not everyone has been able to unwind their positions because there are not natural buyers on the other side of the trade. |
“Many investors have chosen to own more government gilts and duration exposure as a bar-bell strategy because the longer the maturity, the more responsive the price of the bond is to a given yield change,” says Mr Jenkins. “If economic growth slows and yield spreads widen, government bond yields will fall and their prices will rise.”
Risk management the priority
A recent survey of European pension funds by Mercer, the investment consultants, suggests that risk management will dominate the year for pension funds. Diversification continues to be the recurrent theme with around one in ten funds considering adding exposure to global tactical asset allocation, funds of hedge funds and active currency.
However, private equity, commodities and infrastructure are unlikely to see much asset flow, according to the survey.
“Regarding return seeking assets, a continuing theme is the breadth of asset classes,” says Julian Lyne, head of global consultants for HSBC Investments. “If you reviewed asset allocation even five years ago, you would not have had a conversation about emerging market debt or climate change. We see a whole range of asset classes opening up to get a return and to manage risk by diversification.”
Where portfolio risk has moved on is in its granularity. The fixed interest space demonstrates this very clearly, moving from investment grade corporate bonds, to high yielders to emerging market debt and then emerging market debt in both local and hard currencies.
“This shows the granularity of asset classes that people have become more comfortable with,” says Mr Lyne.
“Risk [management] is about understanding and giving a clear target to fund managers about the level of risk they’ll be prepared to accept with a specific risk/return framework. This is the trend across the globe, in both DB and DC pension schemes.”
HSBC is currently supervising the Hong Kong Mandatory Provident fund’s move into a diversified growth fund with a tactical asset allocation content. “The strength of TAA is that it separates the asset allocation decision from the manager decision, so the multi-manager is not making asset allocation decisions based on whether they have a good manager in a certain asset class,” Mr Lyne says.
Investors are also far more clear about the need to split alpha and beta. “There is no reason to combine the two,” says Jay Moore, managing director of currency management at State Street Associates.
“But most clients are looking for guidance, and there is better justification for why we are here than a standard and naïve hedging set, whether that is 50 per cent or 100 per cent. What we’re tying to do is to retain as much exposure as we can to those currencies that give diversification to the portfolio, looking at correlations and volatility,” says Mr Moore.
An optimal UK or US currency portfolio can for example earn a further 25-75 basis points in risk reduction using optimisation techniques, he says. For a Swiss portfolio that can be even more – a risk reduction of perhaps 300 basis points. Canadian and Australian investors may be no better off hedging their portfolios because the local currency is highly correlated to domestic equities, which are linked in those regions to commodities and so will move in an opposite direction to the dollar, yen and pound.
Liability driven investment
Among pension schemes, liability driven investment (LDI) is high on the agenda. On one level it has been instigated by the corporate plan sponsor because it allows them to segment managing their liabilities and their assets and in turn to separate their managers so visibility is part of the benefit.”
“What we are seeing is a gradual increase in strategies that are more dynamically tailored,” says Malcolm Jones, investment director at Standard Life. “Like anything, as more schemes implement LDI the momentum grows for other companies to follow. There are lots of benefits but for trustees the LDI route initially entails a lot more work and effort.
“Back in time when LDI was mentioned in bear markets it was predominately based around hedging interest rates and inflation,” adds Mr Jones.
“What we’ve seen is that strategies can’t afford to be bond only, hence the growth in diversified growth funds looking to generate cash plus 4-5 per cent but with a lot less risk.”
Some diversified growth funds are fairly constrained, but Standard Life aims to have as wide a universe to choose from as possible. For example, the fund has held 30-year Japanese interest rates for 2.5 years which have produced an income of 7.5 per cent and are inversely correlated to global equities. The Global Absolute Return Strategies Fund’s investors range from £3m to £45m (€57m), but the typical new client is £20-40m and currently selling down some of their equity to diversify.
Regulatory factors
Regulatory factors have also intensified risk management efforts in the pension arena. This includes IFRIC14, an interpretation of international accounting standard IAS19 which clarified the rules on unrecognisable surpluses and specifically set out the circumstances under which companies could not credit a surplus to the balance sheet.
A sponsor can now get its hands on the money only if the surplus is either new contributions or a refund of a surplus, a switch not permitted under many scheme rules.
For the sponsor this means there is no upside when the investments go well, but they still have all the downside when investments go badly, creating significant incentives to split the liabilities and assets.
“Many major companies have already reported surpluses affected by IFRIC14, which was issued last year,” says Charles Cowling, managing director of Pension Capital Strategies.
“It had often been the companies that encouraged risk, but now both the sponsors and trustees are interested in de-risking, so risk management and LDI products are coming to the fore,” he adds.
Last year saw the largest reduction in equity holdings in UK pension schemes – now down to 55 per cent, a 5 per cent drop last year, he says, but the 10 largest companies that have restricted surpluses have reduced their weightings in equities to a much lower 35 per cent.
Pooled funds
Pooled LDI products have made this de-risking much easier for all pensions funds, but particularly smaller ones. According to Mercer’s survey, 20 per cent of the schemes (by assets) have already adopted LDI and the number could double this year as strategies become more accessible.
“We’re seeing a lot more pooled LDI, which is easy to transact,” says Mr Cowling. “The consultant community is better at advising on it – there’s always been a reluctance and problem in getting expertise but that is changing. Now £20-30m sized schemes are putting LDI policies in place,” he says.
Apart from full buy-outs, another new product for de-risking pension liabilities is the Tactica insured plan which received regulatory approval at the end of last year. Straightforward insurance schemes are gradually expected to become more popular. Big banks such as Goldman Sachs will also arrange bespoke, but not insured, solutions.
Mortality swaps
Another potential risk management tool in the pension arena is mortality swaps. However these are hindered by the difficulty of finding counterparties because the risk isn’t homogenous, with schemes varying hugely depending on the workforce.
Putting buyers and sellers together is a non-trivial difficulty. Many entities carry longevity risk, but no obvious UK parties desire it, unlike the US where whole of life insurance policies are commonplace and life companies make more money from customers the longer they live.
Last year JPMorgan launched its LifeMetrics Index, the only international index designed to benchmark and trade longevity risk, but it is said to be difficult to use.
Currency hedging
Currency hedging has surged over the last year. More than one quarter of Mercer’s pension fund clients hedge their currency risk and the average proportion hedged by its clients is 60 per cent.
Most of this is done by asset managers with only 14 per cent done by a third party, such as custodians.
“After years of high return with very little risk, risks must now be managed more tightly,” says Thanos Papasavvas, head of currency at Investec Asset Management. “While the first half of 2007 was all pro-carry trade, the second half was all about unwinding carry trade, and the first quarter of this year has been all about macro-economics.” The CVix index of currency volatility bottomed out at 5 per cent last year, then rose to 13 per cent and is now a stable 11 per cent.
Quant performed poorly for currency, as for most else, in the second half of 2007 and so investors are moving away from quant systems to multi-disciplinary systems with a special focus on fundamental analysis.
One way Investec is harnessing these dynamics is to hold yen as a barometer of volatility. The yen does well because it is low yield and the Japanese current account is positive, the opposite of countries such as Iceland and Romania whose currencies have weakened. During the first quarter of 2008, the weakest five currencies have been the Anglo-Saxon currencies with the poorest current account balances.
Barclays Capital has recently launched its AlphaVol and BetaVol currency volatility indices in an attempt to offer forex volatility systematically for investment. The BetaVol index is designed to go in the opposite direction to equities, particularly when equities are most volatile, while AlphaVol is designed to provide consistent returns above a risk-free rate with a low volatility, and as it is unaffected by the behaviour of equity markets, it is also useful for diversification purposes.
FREEDOM TO INVEST
Despite concern about sophisticated credit products, fixed income managers are still being largely accorded the freedom to invest in the range of emerging market debt, interest rate swaps, inflation swaps and credit default swaps.
 | While many asset managers believe corporate bonds currently offer a rare opportunity, there is no consensus. “History shows this yield spread, although significant by recent experience, to be far less attractive when viewed versus the longer term,” says Andrew Wilson, head of investments at at Towry Law. |
“The Baa-Aaa yield spread spiked up to double current levels in the first half of the 1980s (there was also a spike to over 200 bps in the mid 70s). In the early 1920s the spread averaged over 200 bps and in the late 1930s spiked to 300bps. However of course the real excitement was the Depression and then the spread got to 550 bps! 140bps doesn't look quite such an obvious bargain in this light.
“The best way to play credit and loans may be via hedge funds in the fixed income arbitrage, relative value, and lending spaces,” he suggests. “Or in the case of funds of hedge funds, rolled up into what is known as a ‘non directional’ fund, which has the additional benefit of usually being low volatility. These guys can go both long and short, play the yield curve, the credit curve, distressed debt, and deploy volatility strategies. So rather than taking a directional punt on corporate debt, one can access these differing strategies, which don't rely on you picking the bottom, with managers that have the expertise to get the max out of current conditions.”
HEDGING CURRENCY EXPOSURE
Surging volatility has highlighted the importance of hedging currency exposure, particularly among US investors who historically might not have hedged at all and are now increasing their international holdings. Investors in near fully developed nations are following suit. Hedging emerging market currencies has also boomed, partly as it is becoming less expensive to hedge those currencies, and partly because of fear those currencies could be overvalued. “There is plenty of demand for vanilla hedge contracts. State Street Global Advisors’ (hedging) assets under management have doubled in the last three years, particularly last year when many investors did not realise how much currency can cost until it became tangible last July,” says Collin Crownover, head of currency management at SSgA. “My impression from asset managers was that they had increased their international equity exposure but hadn’t necessarily done anything about the FX risk. Even those who gained from the volatility suddenly realised how much they could lose if currency went against them.”
The market has a history of settling on a ratio for FX hedging that an investor is comfortable with, typically 50 per cent globally, or 75 per cent in the UK. SSgA offers a Dynamic Strategic ‘overlay’ strategy which automatically revalues the hedged ratio based on fundamental valuation metrics over the cycle.
Option-like products are also being developed that limit losses to a premium paid but deliver all the upside if currencies move in the investor’s favour.
GAINING EXPOSURE TO VOLATILITY TRADING
The focus of much volatility trading is the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) which measures the market’s expectation of 30-day S&P500 volatility as revealed in the prices of near-term S&P options. Investors looking to control risk can harness the VIX’s negative correlation with the S&P500 by trading options on it. However the VIX is more popular with speculators who ride its dramatic surges by buying calls when the VIX bottoms out to capture any subsequent upward moves in volatility.
“Volatility is the last diversifying asset class but it is difficult to obtain exposure,” says Andrew Wilson, head of investments at Towry Law. “Expected volatility usually turns out to be more than realised/actual volatility, but the instruments generally give you the implied volatility take away the realised volatility, when what you really want is the realised volatility take away the implied volatility, because this will give big gains when you need them the most such as in times of market stress when equities are likely falling sharply.”
However, it is possible to deliver lower volatility equity exposure through an approach focused on low beta securities. SEI offers a suite of Managed Volatility funds aiming to do this including the US Managed Volatility, Global Managed Volatility and Tax-Managed Volatility funds.
“SEI’s research has shown that the securities market line, which defines expected return per unit of risk or beta, is actually flatter than generally believed,” says Mike Prus, analyst, private client portfolio management, SEI..
“In other words, an investor may be able to capture the equity risk premium over a full market cycle at a 15-20 per cent lower risk/volatility level. This type of investment is most appropriate for investors who need equity exposure for growth, but are also concerned with the potential drawdown inherent in equities – retirees would be one example.”
