The £5.1bn local authority pension fund has reduced its losses in recent equity downturns through a low volatility investment strategy
The Merseyside Pension Fund has 3% of its portfolio invested in a European low volatility equity strategy, which has helped it reduce its downside in volatile markets.
Pension schemes have been urged to consider the following in relation to low volatility equity strategies:
Consider your key stakeholders' appetite for volatility. How much can your members take, how much is the employer willing to bear?
Check the underlying investments. What liquidity and sector-specific risks is your fund manager holding in the fund?
Decide on how much you want to allocate. Do you think equities are set for a surge, in which case you might want to hold off in the short term?
Pension schemes are increasingly looking for ways to mitigate the impact of equity market turbulence on their members' retirement savings.
Lower volatility strategies target investment in stable companies with lower amounts of long-term debt and more resilient share prices.
These funds do best when higher volatility strategies investing in more leveraged, less predictable companies do badly.
Peter Wallach, head of Merseyside Pension Fund, said: “The outperformance of lower volatility stocks is a persistent anomaly that can be exploited at lower risk.
“The risk-adjusted returns are attractive and it has provided some protection in the recent sharp down markets we have seen, including September last year.”
Cutting your losses
The Merseyside fund's low volatility allocation sits alongside two active European equity mandates.
For our pension fund, it certainly helped dampen the downside volatility
The defined benefit fund focuses on how its investments affect its funding position rather than how they move relative to a benchmark.
"Its performance complements the other two mandates that we have," said Wallach in a Clear Path Analysis debate on derisking strategies.
"Our experience has been good over the three years despite investing at the start of a bull run when the strategy significantly lagged sharply rising markets."
He added that an allocation to such a low volatility, or minimum variance, investment was a good strategic decision to take at any point.
"[But] tactically, if you believe the markets are about to have a run then you may want to hold off or commit money in a progressive way," he said.
"For our pension fund, it certainly helped dampen the downside volatility."
But schemes should consider the added risks involved with the investment, Wallach added.
He said: "It is important one looks at the underlying manager and is aware of the extent to which the strategy is invested in small-cap, illiquid stocks has significant sector biases or other potential risks of that nature."
Some stocks may appear to be stable but are hiding other risks that could harm a scheme in the short term.
James Bevan, chief investment officer at CCLA Investment Management, said: "There will be a solid core of investments that are relatively illiquid and therefore exhibit apparent low volatility, while potentially masking significant underlying risks."
Testing your volatility appetite
Not all schemes will have the same capacity for volatility. DB schemes will need to test their employer's willingness to accept volatility in their scheme's funding level.
In the early stages of a DC member’s career, they may have quite a high appetite for absolute volatility
Defined contribution schemes, on the other hand, will need to understand their members' appetite for volatility in their retirement savings.
Alan Pickering, chairman of Bestrustees and a trustee to a number of DB and DC schemes, said: "These appetites will vary.
"It is my job as a trustee to make sure we have an investment strategy, volatile or otherwise, that meets the needs of both parties in the case of both schemes."
DC scheme managers and sponsors will need to weigh up the advantages of a low volatility strategy versus their cost for the individual member.
Members will need access to low cost professional advice to get a sense of how market fluctuations will impact on them over the long term, Pickering added.
"Contrary to some conventional wisdom, in the early stages of a DC member’s career, they may have quite a high appetite for absolute volatility," he added.
"However, as they get to the end of their DC journey, they need to diminish volatility between their asset value and whatever their target use of their pot is."
