With bonds and stocks plunging simultaneously in March, Mona Dohle looks at how pension schemes are navigating the extreme volatility linked to the Covid-19 outbreak.
CalPERS, the $375.8bn (£304bn) pension fund for public sector workers in California was prepared for another downturn. With half its portfolio invested in equities, the scheme implemented a tail-risk hedging programme to cover potential losses in the event of a recession. Unfortunately for CalPERS, its chief investment officer, Yu (Ben) Meng, cut the programme at the end of last year, just months before the outbreak of the Covid-19 crisis. As a result, the scheme has lost out on significant gains from the volatility that has hit the markets since.
The bulk of its hedging programme was run by Universa Investments, a tail-risk hedging firm advised by Black Swan author Nassim Taleb. Universa’s tail-risk fund returned 3,612% throughout March. Needless to say, Meng is now having to explain his decision, amid allegations that the scheme missed out on $1bn (£810m) in returns in March.
The case of CalPERS highlights the challenges institutional investors face during spells of volatility. During the past decade, central banks have dedicated unprecedented volumes of money and energy to keeping volatility at bay, with moderate success. As a result, the standard deviations of major stock market indices such as the FTSE100 and the S&P500 have been relatively limited and while bond markets offer record low yields, volatility has also remained at bay.
Indeed, Meng argued, insuring stock market risks with an options-based hedging programme is expensive and, he claims, inefficient for a large-scale institutional investor like CalPERS. This is a challenge many UK institutional investors might recognise.
In good times, downside protection looks expensive, much like paying for car insurance is a nuisance…until you have an accident.
But despite historically low volatility due to central bank interventions, there have been occasional and sudden stock market plunges, such as the flash crashes in 2010, 2011 and 2015 as well as the February 2018 crash which indicated that something was bubbling under the surface. Indeed, by the end of last year, 57% of professional investors in the UK felt that volatility was likely to rise 2020, according to a survey by HYCM, a broker, while more than 70% of investors in London expressed concerns about sudden market changes.
Underlying these sudden spikes in volatility lies a contradiction. Fuelled by unprecedented central bank stimulus, stock markets have risen to new post-2008 crisis highs and bond yields reached historical lows, but the picture becomes slightly less sanguine when looking at the prospects for the real economy. Over the past 10 years, GDP growth across developed nation economies failed to keep up with pre-2008 levels.
More recently, a sharp spike in US unemployment and gloomy Bank of England forecasts for the UK economy indicate that the economic pain inflicted by Covid-19 is likely to have a lasting impact. As a result, concerns are growing that artificially low volatility due to central bank stimulus measures could conceal risks in the real economy and contribute to a misallocation of investments. The combination of these two risks could lead to the ultimate volatility trap.
Tragedy of the commons
Another factor that has added to rising tensions is the changing nature of brokerage and liquidity provision in the aftermath of the global financial crisis. As banks are facing increasingly tighter rules on capital requirements, they have significantly scaled back their brokerage activities, with severe implications for market liquidity.
As a result, the nature of liquidity provision has changed dramatically, according to Richard Tomlinson, chief investment officer at Local Pensions Partnership (LPP). “Banks aren’t there anymore to provide liquidity because of capital requirements and constraints on their balance sheets. It has changed massively.
“A lot of the liquidity is now provided by what you would call hedge funds and high-frequency traders and many of them run themselves in similar ways,” he adds. “Many of those businesses run themselves with similar risk management profiles and are able to, if they don’t like the opportunity set in front of them, simply shut down.”
Barry Kenneth, chief investment officer of the Pension Protection Fund (PPF), has observed those changes from the other side of the fence, having been a managing director at Morgan Stanley in the midst of 2008’s downturn. He also notes that banks’ are no longer as willing to take on risk. “Banks almost act like brokers rather than intermediaries,” Kenneth says.
“In good times they provide capital to intermediaries, but when things become stretched and markets become extremely volatile the tendency to take on risk is a lot less than we would normally see,” he adds.
The trend of more sudden market movements is further aggravated by other structural changes which have taken place since the 2008 crisis. One is the growing dominance of passive investing, which itself is linked to the emergence of high-frequency trading. Over the past 12 years, assets managed passively have quadrupled to $3.5trn (£2.8trn) while the majority of US equity trades now occur electronically.
For Tomlinson, the growing impact of risk parity programmes, which switch between assets based on changes in volatility, is another manifestation of these challenges. “People have pointed the finger at risk-parity programmes, which is potentially reasonable,” he says.
“As volatility has risen, many risk-parity programmes had to deleverage, which has led to wholesale selling of pretty much every asset, creating a vicious effect. Risk-parity programmes are, of course, not the only factor in that, there are many others as well, but it is clearly the clue to deleveraging.”
While these strategies offer individual investors the ability to respond to changing markets more swiftly and cost efficiently, they have increased the risk of markets moving swiftly in one direction. Put differently, what may be a rational approach from an individual investor’s perspective may not necessarily be beneficial to overall market stability, a contradiction dubbed “tragedy of the commons” by 19th century economist William Forster Lloyd.
Covid impact – strange relationships
The sum of these contradictions came to play in March when the VIX rate, a volatility index based on S&P500 option pricing, surged to 82.9 basis points from less than 14 basis points in a single month. While sudden changes in equity markets are nothing out of the ordinary, investors became concerned as the crisis spread to other asset classes.
For John Roe, head of multi-asset fund management at Legal and General Investment Management, this suggested that the global economy was on the brink of something much more serious.
“We started seeing strange relationships, for example, when real yields on US inflation and government bonds went from -50 basis points to +60 basis points in less than two weeks,” he said. “That’s when the thing changed from being about fundamentals to being about leverage and the unwinding of leverage and of bank balance sheets. The volatility was no longer about the virus, the concern then was that if central banks don’t step in fast and control this volatility, we are going to see the mass liquidation of assets across all markets.
“There was a one week period where we felt that the Fed and other central banks should get involved fast to bring this volatility down, or this is going to get so far out of control that the virus is going to be an afterthought.”
Roe and Kenneth identify the sudden changes in what were previously thought to be safe haven assets as indicative of structural market shortfalls. “All you have to look at is some of the things that have happened in the past four to six weeks,” Kenneth says. “If you look at things like WTI and the commodities market, they are trading in the negative 40s so you have to pay $40 to deliver a barrel of oil. The oil market has never traded below zero before.”
While all asset classes were equally affected by the sudden surge in volatility, the contradictions were most obvious in fixed income markets. Stuart Trow, credit strategist at the European Bank for Reconstruction and Development, recalls: “The clear divergence between investment grade and non-investment 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 disappear yet at the same time the primary market grew and grew. We got to a situation whereby if you ever needed to sell, everybody 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 probability 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 liquid assets. “Selling treasuries and selling gold is part of raising dollars,” he says.
LPP’s Tomlinson also recognises this pattern in equity markets. “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 liquidations people try and shift risk off using index positions, derivatives 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 untouchable, 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 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 managers 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, particularly 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 initial 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 simultaneously 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.”
Schemes’ ability to respond to the crisis also depends a lot on their maturity. For local government pool LPP, which unlike many defined benefit (DB) schemes is still open, the recent volatility could offer buying opportunities. Chief investment officer Tomlinson stresses that with liabilities in excess of 20 years, the scheme has the opportunity to take a long term-view on the crisis and invest. Nevertheless, he remains cautious, arguing that the dip might not have reached its trough yet.
For PPF chief investment officer Barry Kenneth, holding a cash buffer has become a key element of downside protection. The scheme has been overweight on cash for more than a year. With relatively high funding levels prior to the crisis, the scheme could afford the expense of holding cash, which it then put to use by buying investment grade-debt at high-yield spreads throughout March, Kenneth says.
BT’s Francis also increasingly sees a merit in holding cash. “I have been talking about this internally for a while, the optionality of holding cash has been quite attractive. With asset classes yielding so little anyway, the cost is also not that high. Having cash has allowed us to invest in corporate bonds at much more favorable rates,” he says.
While holding cash and investing in falling markets has played out well for some schemes, it can play a role in offsetting some of the systemic factors that have contributed to a decline in liquidity and increased volatility, says LGIM’s John Roe. “You could just say schemes are buying cheap assets but what this is really about is providing access to cash at a time when everybody wants cash,” Roe says.
He adds that his team increased the credit holdings in some of its portfolios by 7% to 8% throughout March.
There is, of course, an element of danger to such interventions as default and liquidity risks are rising. Roe argues that spreads between credit default swaps and cash instruments can provide an indication of the liquidity premium. “They both provide access to the same credit name but one of them you need liquidity for because you need to pay for the bond, the other one, credit default swaps, is an unfunded instrument, so you don’t need liquidity to access it,” Roe says. “When you see the spreads between the two widening, that is an indication of the liquidity premium.”
While markets appear to have reverted to relative normality, investors harbor no illusions, volatility is likely to become a recurrent challenge for institutional investors. Many pension schemes have already factored this into their portfolio strategies, either by reducing equity exposure, implementing hedges or holding additional cash reserves.
Whatever decisions individual schemes take to manage their volatility, they will have to strike a careful balance between the best interest of their members, and how their investments impact overall levels of volatility.
