How schemes can protect against equity losses

Many pension funds have adopted implicit forms of downside protection through diversification strategies. But over the past 12 months or so, there has been increased demand among investors for more explicit forms of protection against equity losses as artificially-stimulated asset prices have given way to higher market volatility, geopolitical tensions and trade war concerns.

A new report by consultancy Bfinance called DNA of a Manager Search: Equity Overlay, looks at how these strategies work and why they have become more popular.

Bfinance managing director for risk and diversifying strategies Toby Goodworth explains: "The prospect of severe downturns has strengthened the case for more explicit safeguards on investment portfolios, where equity overlay strategies are being sought, in contrast to the past decade where investors had been building up implicit downside protection through diversifying strategies."

Explicit protection

This is part of an increased trend to put protection in place of some form. In 2018, Goodworth did a greater variety of projects than ever before - all looking to control or reduce equity beta in the portfolio. 

"That might be explicit protection like a risk overlay, or implicit protection in a move towards greater allocation of liquid alternatives be that hedge funds, risk premia or even currency overlay," he says.

Over the past year or so, there has been a string of Local Government Pension Scheme (LGPS) funds adopting derivative-based overlay strategies ahead of their 31 March 2019 triennial valuations to hedge against a significant fall in equities, after their funding levels improved on the back of rising markets.

Worcestershire, Cumbria County Council, South Yorkshire Pension Authority, and more recently Tower Hamlets, are just some of the LGPS funds that have gone down this route, and for the first time.

Bfinance recently helped find a manager to implement an equity protection strategy for an unnamed UK public sector pension fund. The scheme opted for medium-term protection, preferring a straightforward structure using a put-spread collar. It was willing to give up equity market gains above 10% and participate in losses up to 10%, with protection required from -10% to -30%.

"It might be that risk overlay is as much a necessity as it is a choice of investment," says Goodworth. "It could be where schemes have triennial valuations coming up or that the capital invested in equities has already been earmarked for some other usage at a later date, and therefore you don't necessarily want that capital to be subject to the full weight of equity market volatility. It's essentially forward planning, and risk overlay can be useful tool for that. 

"2017 was one of the lowest years on record for equity market volatility, so we're clearly in a trend where volatility will be higher going forward. Schemes can use risk overlay or a collar to limit the potential path dependency if they need to withdraw it in a year's time for example."

Future take-up

To what extent will we see more pension schemes go down this route?

Such strategies will only be relevant where a scheme has a high equity allocation - which is the case for most LGPS funds as they are still open. Where private sector schemes are concerned, most are closed and on a de-risking journey. "A lot of private sector UK schemes didn't put protection on for the simple reason they were scaling back their equities as markets rose and funding levels improved," according to Mercer director of investments Hemal Popat.

Given the March 2019 valuations are less than three months away, he says few if any LGPS funds are putting on equity protection strategies now.

But what has been the experience of those LGPS funds that have used protection strategies?

"All of our LGPS clients that adopted protection strategies at various points during 2018 and even 2017 are pretty comfortable with the logic for going in," says Popat. "At the year-end, they were significantly in the money. They've gotten more value from the protection than they've paid out by selling upside."

There are two main types of overlay equity strategies: static and dynamic. Static, which has been common among LGPS funds, is a ‘set and forget' strategy that involves going in on a single date and protect equities until some specific future date, and typically does that to lock in good market levels. A dynamic approach would involve active trading throughout the period, using a series of overlapping option positions to create a more complex solution, with protection levels evolving with the market.

According to Bfinance, the costs of a static strategy range from three to six basis points (bps) per annum, while dynamic strategies can incur between eight and 30 bps of fees. The consultancy also identifies a third strategy that sits between the two - ‘evolving static' - which adjusts the hedge and establishes a new option position should market dynamics change over time.

The next question for LGPS funds is whether they extend their static strategies beyond the planned end date.

Popat says: "I think we'll see LGPS funds that already had strategies say that they've worked for them, and extend them for another one, two or three years. Some will let it lapse but not that many because LGPS funds are open and they've got to continue achieving gilts-plus or cash-plus returns. So the question is ‘how do I do that in a risk-controlled manner?' Until they find a better asset class that has superior risk-return trade-off to protect equities, it's not clear what viable options there are.

"Those LGPS funds will want to look at their funding level, return requirements, how the equity protection strategy performed, and how they did versus the average scheme."

Popat thinks that going forward there will be a shift from static strategies towards dynamic strategies, which roll over constantly. He explains how dynamic works: "Everyday some of your protection will expire and you'll put on some new protection. The benefit of that is it's much less sensitive to the market level because you're constantly averaging.

"That becomes a more evergreen, risk management strategy, than not trying to lock into a higher watermark. As time goes on, we expect an increasing number of LGPS funds will look at rolling strategies which just give a risk-managed equity outcome."

Six key questions to ask

1. How long should the protection last for? Depending on the purpose of hedging and the cost of appropriate options at the time of implementation, it could make sense to apply a put-spread collar for any period of time between one and three months and one and three years.
2. How much manager discretion would be tolerated? A static approach would be a ‘set-and-forget' strategy; evolving static would be a sub-division into shorter periods, and a dynamic approach would involve active trading throughout the period.
3. What costs am I willing to bear?
4. Where do we want to place the strikes? This is a question of how much upside participation to give up and how much downside protection to bear.
5. How should collateral be treated?
6. How closely should the protection match my portfolio?

Source: Bfinance - DNA of a Manager Search: Equity Overlay