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In liability-driven investing (LDI) it is common practice for pension plans first to construct a bond portfolio that matches the risk profile of their liabilities using a predetermined fraction of their assets, and then allocate the remaining fraction to risk assets, such as equities, real estate, and private equities. Frequently, the allocation among the risk assets is performed independent of explicit consideration of the liabilities and is strongly tilted to equities.
Figure 1 compares how duration and credit have diversified equity risk historically, based on close to forty years of monthly data (from February 1973 to February 2012). It shows full-sample correlations, as well as tail event correlations, which are calculated on months during which equities – as represented by the total return on the Wilshire 5000 Index – were down by two standard deviations or more relative to their average return. Standard deviations are calculated over the full sample. Here, duration is represented as the total return of the Barclays Intermediate Treasuries Index, while credit is return per unit of duration for the Moody’s BAA spread over Treasuries.
Over the full sample, both correlations are low and slightly positive: 8% for duration and 3% for credit. However, during tail events, duration typically experiences a flight-to-safety rally, while credit spreads “blow up” (which means, credit crashes with equities). Figure 1 also shows the tail event correlation between duration and equities is - 48%, compared to + 82% for the credit risk factor.
From an asset-only perspective, the obvious conclusions from this correlation analysis are that: a) in a risk selloff, the portfolio may benefit from a rally in Treasuries, and b) credit is a poor diversifier of equity risk in the portfolio. But from an asset-liability perspective, these duration diversification dynamics must be interpreted carefully – most plan sponsors are short duration because their liabilities have longer duration than their total asset portfolio. If rates rise, they may benefit. But for those plan sponsors, there’s no such thing as a flight-to-safety diversification effect between duration and equities. During a “risk off” event, they will likely experience a double whammy: their equity portfolio will likely lose value and their liabilities will balloon faster than their bond portfolio, on a dollar value basis. Hence, plan sponsors who wish to reduce their funded status risk should consider increasing allocation to Treasuries and recognize their funded status may benefit from a rally in duration during equity drawdowns only once they become net long duration. Plan sponsors who are unwilling to increase duration or face constraints in this regard should pay special attention to identifying alternative sources of diversification within their risk assets.
Overall, when diversifying across risk assets, there are choices that may be more attractive to pension plans than they are to liability-agnostic investors, such as risk assets with exposure to duration. The exposure may be explicit fixed income exposure, of which emerging market debt would be a clear example, or exposure to private and illiquid asset classes whose valuations are strongly linked to present value discounting processes.
Solution: a diversified portfolio of alternativesPutting it all together, plan sponsors who choose to maintain a short duration stance on a total portfolio basis should consider alternative sources of diversification beyond equities, and they should focus on risk assets with indirect duration and credit exposures.
Figure 2 shows an example of the diversification benefits that may be achieved by substituting a portion of a plan’s equity portfolio for commodities, emerging market local debt and an absolute return strategy. The equity focused allocation is comprised of 70% equities, while the diversified risk assets allocation substitutes half of the equity allocation for an equally-weighted portfolio of these three alternative asset classes. Both allocations invest 30% in an LDI immunization, fixed income portfolio. The bottom of the exhibit compares risk decompositions for the assets themselves, and for the assets net of the liabilities (“surplus” risk decomposition). Decomposing surplus volatility into its risk factor contributions reveals that while duration potentially reduces portfolio risk on an asset-only basis, when the pension plan is net short duration, it may contribute to portfolio risk on an asset-liability basis. However, this does not mean that exposure to assets with duration is contributing to risk: rather, it is the insufficient exposure to duration that causes the risk.
This solution offers 3% to 4% in potential volatility reduction. The cost of this risk reduction depends on the difference between assumed returns for equities and for the diversified risk asset portfolios. Once assumed returns are determined, plan sponsors should assess how much return they are willing to sacrifice in order to reduce risk. While this example was not explicitly optimized, an optimization process that incorporates the liabilities can be used in an effort to efficiently scale the risk asset positions. This example is meant for illustrative purposes, as different portfolio structures will be appropriate for different investors and yield different results.
In general, from an LDI perspective, plan sponsors who are constrained or choose to remain short duration may want to consider risk assets that offer alternative sources of equity risk diversification, such as commodities, as well as assets with stable cash flows – and hence greater indirect duration and credit exposures – such as high-dividend stocks, real estate, infrastructure and some hedge funds. Duration exposure from markets that are not at their zero-bound and for which debt-to-GDP levels are reasonable, such as emerging market bonds, may also provide incremental returns while reducing risk to the funded status. In all cases, plan sponsors should carefully evaluate correlations in times of stress before optimizing their portfolio.
Takeaway: Alternative sources of diversification In liability-driven investing, unless the plan is fully immunized (fully invested in a liability-matching portfolio) or significant leverage is employed, the bond portfolio only hedges part of the liabilities. Hence, plan sponsors should consider applying the same concepts they use to construct their LDI bond portfolio to the selection of risk assets. Doing so reveals the need to balance risk assets across alternative asset classes differently than from the asset-only perspective, especially as it relates to the role of direct and indirect credit and duration exposures in the portfolio. Investors who must remain net short duration should consider alternatives sources of diversification as well as indirect duration and credit in their risk asset portfolios. Several asset classes offer such characteristics, such as emerging markets bonds, commodities and hedge funds.Rene Martel, Vijendra Nambiar, Fei He and Jared Gross contributed to this analysis.
Figure 2 - additional informationOther risk factors include equity value, growth, momentum, slope and other equity industry factors. Volatility is the standard deviation of returns; volatility contributions are given by the product of the risk factor exposure, its volatility and its correlation with the entire portfolio. Asset class proxies are: U.S. Equities, Russell 3000 Index; International Equities, MSCI All World ex-U.S. Index; Fixed Income, Barclays Long Credit Index (55%), Barclays Long Government Index (15%), Citigroup 20+ Strips Index (30%); EM Local, JP Morgan Government Bond Index-Emerging Markets; Commodities, Dow Jones UBS Commodity Total Return; Hedge Funds, HFRI Fund Weighted Composite.Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.The correlation of various indices or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.The Barclays Capital Intermediate U.S. Treasury Index is an unmanaged index representing public organizations of the U.S. Treasury with a remaining maturity of one year or more. The Barclays Capital Intermediate Investment Grade Corporate Index is an unmanaged index of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. The Barclays Capital Intermediate U.S. Treasury Index is an unmanaged index representing public organizations of the U.S. Treasury with a remaining maturity of one year or more. The Barclays Capital Intermediate Investment Grade Corporate Index is an unmanaged index of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. It is not possible to invest directly in an unmanaged index. Barclays U.S. Long Credit Index is the credit component of the Barclays US Government/Credit Index, a widely recognized index that features a blend of US Treasury, government-sponsored (US Agency and supranational), and corporate securities limited to a maturity of more than ten years. Barclays Long-Term Treasury consists of U.S. Treasury issues with maturities of 10 or more years. Citigroup STRIPS Index, 20+ Year Sub-Index represents a composition of outstanding Treasury Bonds and Notes with a maturity of at least twenty years. The index is rebalanced each month in accordance with underlying Treasury figures and profiles provided as of the previous month-end. The included STRIPS are derived only from bonds in the Citigroup U.S. Treasury Bond Index, which include coupon strips with less than one year remaining to maturity. The index does not reflect deductions for fees, expenses or taxes. The Dow Jones UBS Commodity Total Return Index is an unmanaged index composed of futures contracts on 20 physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. Prior to May 7, 2009, this index was known as the Dow Jones AIG Commodity Total Return Index. The HFRI Fund Weighted Composite Index is comprised of over 2000 domestic and offshore constituent funds. All funds report assets in USD and report net of fees returns on a monthly basis. There is no Fund of Funds included in the index and each has at least $50 million under management or have been actively trading for at least twelve months. The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are comprehensive emerging markets debt benchmarks that track local currency bonds issued by Emerging Market governments. The index was launched in June 2005 and is the first comprehensive global local Emerging Markets index. The Morgan Stanley Capital International All Country World ex-U.S. Index (“MSCI ACWI ex-US”) is a market capitalization weighted index composed of approximately 2000 companies, and is representative of the market structure of 21 developed countries in North America, Europe, and the Pacific Rim, excluding securities of United States’ issuers. The index is calculated separately; without dividends, with gross dividends reinvested and estimated tax withheld, and with gross dividends reinvested, in both U.S. Dollars and local currency. The Russell 3000 Index is an unmanaged index generally representative of the U.S. market for large domestic stocks as determined by total market capitalization, which represents approximately 98% of the investable U.S. equity market. It is not possible to invest directly in an unmanaged index.This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. © 2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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