Riding choppy markets: Are equities worth the associated risk?

With equities still making up the majority of schemes’ portfolios, market volatility can present a real risk.

People are really interested in ways they can keep their exposure to equities but somehow smooth those periods of heightened volatility 

Dan Mikulskis, Redington

The FTSE 100 saw a significant slide last week after a period of relative calm in equity markets.

And a further rise in volatility is expected as troubles in the eurozone continue and the UK feels the impact.

Interest rate rises in the UK and US, and geopolitical risks such as the Ebola pandemic and the threat from Islamic State of Iraq and the Levant, are also expected to rattle the markets.

Dan Mikulskis, co-head of asset and liability modelling at consultancy Redington, says even though history shows equities go through periods of heightened volatility that can lead to bad outcomes for investors, many schemes believe in equity risk premia in the long-term.

He says: “People are really interested in ways they can keep their exposure to equities – which is their long-term aim – but somehow smooth those periods of heightened volatility or protect themselves against them in some way.”

Ciaran Mulligan, head of manager research at Buck Consultants, says equities have brought much needed volatility to pension funds, adding: “Simply because without volatility, you can’t expect to have returns.”

But over the past couple of years, says Mulligan, schemes have been looking at that volatility and at the amount they are running in portfolios.

He adds: “And typically most people didn’t want to stomach the volatility because it has the possibility to give you sharp drawdowns in an asset class such as equities.”

The way in which schemes decide to mitigate the volatility is a function of the governance of the scheme, the level of trustee knowledge, the decision-making structure and size of the scheme.

Investment consultants identified three ways schemes are dampening equity volatility in their portfolios: decreasing allocations, diversifing investments and implementing hedging programmes.

Deon Dreyer, principal investment consultant at Quantum Advisory, says one way schemes are managing the risk is “an outright decrease in equities”.

According to this year’s UBS Global Asset Management’s Pension Fund Indicators, the average UK pension scheme currently has 46 per cent in equities. This is down from a peak of more than 80 per cent in 1993.

A key finding of the survey, however, was that the much discussed equity exodus has slowed.

Schemes have also been diversifying across risk factors and asset classes. “An individual asset class by itself might deliver a relatively bumpy return over the longer term, but if you combine asset classes you get a smoother return,” says Mikulskis.

Schemes have also been diversifying equity holdings to include strategies such as low-volatility equity.

“The most common ways schemes are mitigating is through investment in diversified growth and absolute return funds,” Dreyer said. These funds offer equity-like returns with downside protection.

They also have the added benefit of having a good track record through equity volatility.

“While previously schemes allocated to just one manager, [they] are now slightly more astute and are now allocating to multiple managers to mitigate the key-man risk associated with some of these funds.”

Buck’s Mulligan says: “A lot of larger schemes are implementing tail-risk hedges.”

Some have been buying options on the Vix – the volatility index. With volatility low in June, July and August, options were cheap.

Mikulskis says there has been a lot of interest among schemes for downside protection.

“[However], when you are buying options to protect your portfolio against the downside, you should expect to give up some expected return,” he says. “You are expecting that insurance, if you like, to pay out in some years but a lot of [the] time it won’t pay out, and over time you expect that to represent a bit of a drag on portfolio in terms of return.”