Cover story
ment grade has certainly focused our thinking.” While Trow has expressed concerns about liquidity in fixed income markets before, he said it had been an eye opener to see just how friendless non-investment grade bonds were. “All of the sudden, banks could no longer afford to hold credit as inventory,” Trow says. “That made the secondary market dis- appear yet at the same time the primary market grew and grew. We got to a situation whereby if you ever needed to sell, every- body seemed to be doing the same and the market would move quickly to reflect that. “The one thing credit hates is volatility,” he adds. “It is a lazy proxy for the risk premium, but high volatility is absolutely the last thing credit wants to see.
“The other issue with that is that we have to factor in a proba- bility of increased defaults going forward,” Trow says. “In the high yield space, we will be looking at defaults. That’s not something we have been used to in the last few years.” The key explanation for these seemingly irrational market movements, where presumed safe haven assets are becoming much harder to trade, are the changes in market structures and liquidity provision, Trow argues. Faced with a crisis, banks and high-frequency trading firms swiftly disposed of the most liq- uid assets. “Selling treasuries and selling gold is part of raising dollars,” he says. LPP’s Tomlinson also recognises this pattern in equity mar- kets. “From the conversations we had internally, we observed that the very liquid assets moved the most. That is of course completely understandable, if you have large top-down liquida- tions people try and shift risk off using index positions, deriva- tives and, potentially, ETFs. The quickest way to hedge that is to pick a basket of liquid names, to pick index constituents. You wouldn’t trade in the smaller or mid-cap range,” Tomlinson says.
One striking aspect of the current crisis is that just as swiftly as correlations reversed, they eventually normalised again. By mid-March, all asset classes reported red figures that were deep in double-digit territory. But in the last week of March, due to unprecedented levels of central bank interventions, bond and stock market indices suddenly swung up again. “It was over so quickly that it’s almost like it never happened, but when we were actually in it, nothing else mattered,” Roe says.
Investment implications With even gold and treasuries temporarily becoming untouch- able in the event of a downturn, the basic principles of modern portfolio theory appear to have been thrown out of the window. What are pension schemes doing to protect their portfolios from a potentially much more volatile market environment? While few schemes have predicted the risk of a virus grinding
24 | portfolio institutional May 2020 | issue 93
the global economy to a halt, the risk of an increase in volatility has already been on the agenda. Wyn Francis, deputy chief investment officer at the BT Pension Scheme, which manages more than £50bn in assets, says the scheme had already been on a trajectory to reduce downside risks. “For the last few years, we have been reducing the amount of growth assets in the scheme and much of that has come out of our equity allocation,” Francis says. “At the same time, we have been reducing the number of man- agers we have by making some mandates larger with a focus on active management,” he adds. “And the reason we have been doing that is pretty much for the kind of situation we have had for the past few weeks. We want to be quite defensive, par- ticularly when markets are volatile and selling off. For that, we are prepared to give a little bit of way in strong markets, so that’s the offset.” Unlike CalPERS, which sold its tail-risk mandates, Francis believes that hedging can also be beneficial for large scale investors. “We have also introduced systematic hedges to a substantial part of our equity portfolio, effectively selling short- term volatility and buying longer term volatility. We wanted to run more exposure on our growth portfolio for longer,” he says. “That hedge allowed us to hold that growth portfolio and de-risk progressively as markets increased, that has helped quite a lot over the most volatile period.” Despite being, by UK standards, a large institutional investor, lack of depth in the options market was not a concern for BT’s retirement scheme. “I don’t think we have found a problem in being able to size the hedge in the way we wanted,” Francis says. “Liquidity wasn’t great when we wanted to restructure the portfolio after the ini- tial sell-off, but we managed everything that we needed to do. We had to be circumspect and do it over a couple of days, rather than trying to do everything in one go.” Trow, who is a trustee of the pension scheme for the European Bank for Reconstruction and Development, pursues a similar approach, which he describes as a “barbell strategy’’, focusing on holding relatively high risk and low risk assets simultane- ously whilst avoiding middle-of the road choices. “We kept our equity holdings but offset that with index-linked bonds,” Trow says. “Mark-to-markets aren’t pretty, but they are well within our funding tolerances.” But getting the timing right has been difficult for many schemes, Trow adds. “Before the crisis the challenge was that you often had pension funds thinking about how they were going to de-risk their portfolios, but it was difficult to see how they would do that as equity returns and dividend yields were pretty attractive and bonds were paying very little. So it wasn’t obvious where to de-risk from equities and had you done it too early you would have missed out on quite substantial gains in the stock market.”
Page 1 |
Page 2 |
Page 3 |
Page 4 |
Page 5 |
Page 6 |
Page 7 |
Page 8 |
Page 9 |
Page 10 |
Page 11 |
Page 12 |
Page 13 |
Page 14 |
Page 15 |
Page 16 |
Page 17 |
Page 18 |
Page 19 |
Page 20 |
Page 21 |
Page 22 |
Page 23 |
Page 24 |
Page 25 |
Page 26 |
Page 27 |
Page 28 |
Page 29 |
Page 30 |
Page 31 |
Page 32 |
Page 33 |
Page 34 |
Page 35 |
Page 36 |
Page 37 |
Page 38 |
Page 39 |
Page 40 |
Page 41 |
Page 42 |
Page 43 |
Page 44 |
Page 45 |
Page 46 |
Page 47 |
Page 48
