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Managing risk in turbulent times


Jonathan Joiner, senior solutions strategy manager, and Peter Boakes, solutions strategy manager, Legal & General Investment Management (LGIM)


2018 will probably be remembered as the year volatility returned to the market. As highlighted in our CIO’s investment outlook, there are a number of tail risks on the horizon that could cause this to continue. While there is no panacea for market volatility, these four simple steps can help reduce the impact.


1. Diversify by geography and asset class


In figure 1 we introduce an example pension scheme and show the effect of diversification on risk. The scheme’s current portfolio is a classic 60:40 split of equity and bonds which has an expected return of 2.7% over gilts but is exposed to significant downside risk, with a one-year funding level at risk (FLaR) of 13.8%.


This means that over a one-year period, in a 1-in-20 event, the funding level is expected to drop by 13.8%. In the right hand portfolio, we have diversified the asset allocation. The expected rate of return is unchanged but the risk (measured by FLaR) has been reduced by c.25%.


Diversification is not a new concept and UK pension schemes have certainly made improvements in this area. However, we believe there is still room for further improvement. For example, schemes with less that £10m of assets under management still have, on average, 40% of their equity exposure in UK equities.


This compares to just 15% for schemes that are over £1bn. This leaves smaller schemes in a higher risk position where they are more susceptible to UK-centric shocks.


Figure 1: Risk reduced while maintaining expected return


Initial Portfolio


Diversified Portfolio


30% Equity (UK)


30% Equity (Overseas) 20% Investment grade credit (UK) 20% Government bonds (UK)


6% Equity (UK) 14% Equity (Overseas) 4% Equity (Emerging markets) 11% Investment grade credit (global) 4% High yield bonds 6% Emerging market debt


Expected rate of return over gilts (% p.a) 1 year 95th percentile FLaR


Initial funding level is assumed to be 80% on a gilts flat discounting basis


Initial Portfolio 2.7%


13.8%


4% Property 5% Global REITs 4% Global infrastructure 2% Private equity 1% Commodities 38% Government bonds (global)


Diversified Portfolio 2.7%


10.3% Source: LGIM


24 April 2019 portfolio institutional roundtable: Managing volatility


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