Thursday, February 13, 2014

Why do UK pension funds drive without an airbag?
Guest post by Paul Blyth. What do people think? "Many leading European pension funds, insurance companies, and hedge funds have been actively controlling the volatility of their investment portfolios for many years and to positive effect; S&P has been running indices in this area since September 2009; and yet UK pension funds seem barely aware that there are tried and tested techniques to manage the downside risk associated with high volatility in mainstream equity portfolios.   

This post attempts to provide a very high level introduction to the subject.

What’s the big idea?

By controlling volatility in your portfolio it’s possible to avoid the catastrophic impact of major market crashes.

What’s the theory?
·      Knowing today’s closing price (e.g. FTSE-100 index level) is no use at all in predicting tomorrow’s price, next week’s price etc. i.e. it’s a random walk.  By contrast, knowing today’s level of volatility in price does help you to predict tomorrow’s volatility, and the day after, and the day after that etc., in fact there is ~30% correlation between today’s volatility and the volatility that follows – this predictive ability diminishes over time and disappears after ~100 days.
     Higher levels of volatility in equity markets are strongly co-related with under performance and most importantly with major drawdowns and crashes.
·      Ergo, we can use today’s volatility to help us predict tomorrow’s volatility, and if tomorrow’s volatility is forecast to be high, then we should “get out” of the market to reduce our chance of having a crash.

OK in theory, but how do I implement this?
·         Set a maximum level of volatility for each element of your portfolio - aka a risk budget
·         Review the volatility on a periodic basis (we recommend daily)
·         If the volatility stays within your budget (most of the time) – do nothing – this is primarily a “do nothing” strategy.
·         If the volatility breaches the risk budget limit, then reduce your exposure to the market as per your risk budget.
Is this going to mess up my strategic asset allocation and other parts of my risk management? 
No.  This strategy is implemented by means of a Risk Overlay i.e. you can leave everything just as it is and put an “overlay” on top of your equity portfolio.
 Is it legal for local authorities? 
 Our lawyer says “Yes” (do check with your own).  Using derivatives to manage downside risk of an   existing portfolio is not speculative and therefore allowed under LGPS rules.
Where’s the catch?
This strategy “does what it says on the tin” - it manages your volatility.  It does not promise to deliver improved return or protect you against all drawdowns.  History shows us that times of high volatility are often associated with significant falls in equity markets, but this will not be the case for all equity markets for all time periods.
What’s with the airbag?
The analogy is that you continue to “drive” your pension fund however you like and at whatever speed you like i.e. you’re in control of SAA, risk budget etc., and the Risk Overlay is the “airbag” that helps protect you at times of accident … it does not prevent an accident from happening, but it may just save your life if you get into a crash.
What does the chart look like?
Since the turn of the century[1], the S&P500 has returned 44% to investors with a volatility of ~21%; implementing a simple Risk Overlay (RO) would have reduced volatility by a third and increased returns to 65% (see chart below).

Author:  Paul Blyth, Fundo S.A.

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