Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer

Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer



 

Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer

The events of 2008-09 prompted a long hard look at traditional investment portfolios; they were found to be flimsy in the face of the crisis, despite according with principles enshrined in a half-century or so of academic research. Since then, academics and others have suggested ways in which portfolios could have been constructed to fare better. Here, we examine one such approach – risk parity.

Portfolio construction has always been about putting an investment portfolio together in the simplest way that takes an agnostic approach to future asset returns and risks. The investor seeks to separate the strategic from the tactical, stepping back from forecasts and allocating for the long term, independent of market views.

Harry Markowitz in 1950 established the idea of the efficient frontier, laying the foundations of portfolio theory, the principles of which still stand. We suggest the following three steps can be used to address the portfolio construction challenge:

• Decide on the sources of return for which there is a fundamental reason. Not all risks are rewarded.

• Combine these, using available asset classes, in the way most neutral to a view on their future behaviour. Do not introduce spurious dependence on uncertain estimates.

• Scale the overall allocation to meet the return target and risk budget of the investor.

The obvious outcome of such principles is a portfolio which has at its core (but is not limited to) an allocation to liquid markets according with the risk parity principle.
 

Traditional portfolio construction

Although frequently and conveniently used as a benchmark, in reality a 60/40 stocks/bonds portfolio was never a standard asset allocation. Many pre-crisis portfolios, though, did feature fixed weight allocations to asset classes; allocations split between a ‘return-seeking’ portfolio, made up of asset classes assumed to provide risk premia (often equities) and a ‘low-risk’ portfolio (often domestic government bonds), split according to risk appetite; and allocations to credit and the dangerously-named ‘alternatives’ (comprising a variety of assets from hedge funds to private equity and currency).

Looking back, it is clear that a disproportionate amount of portfolio risk stemmed from the equity allocation. Credit tumbled with equity in 2008, and it transpired that many strategies in the alternatives bucket were, in fact, vulnerable to a broad liquidation of asset positions, meaning they plunged in value together. It also became clear that many active managers were doing nothing more than systematically harvesting existing risk premia. The realised equity risk premium over the last 10-15 years was in fact much lower than investors expected ex-ante, and the misguided dependence on this asset class was exposed.

Conversely, risk-adjusted returns of bonds were higher.

These reflections naturally led investors to reassess diversification. The focus shifted towards finding genuine risk premia in asset markets, regardless of market views. The result was a dynamic allocation to each risk premium, keeping the risk from each source constant and equal – risk parity began to attract interest. One 2012 survey covering 24 investment-consulting firms found that 78% of them undertook coverage of risk-parity managers, with 91% of those recommending them to clients.
 

Less is more

The bedrock of risk parity is the idea that allocation should be to sources of risk premia, not to asset classes, and that those sources of risk premia should be as diverse as possible. Academic research has suggested that the number of genuinely diversified sources of risk premium could be less than conventionally thought –maybe no more than three or four.

Focusing on such a small number of sources of return might seem overly simplistic, especially considering portfolio construction prior to 2008 emphasised ‘diversifying’ across many, many assets. The risk-parity portfolio can cover an investor’s exposures to liquid risk premia, but some assets fall outside of this and should still form a part of an investor’s portfolio – for example contractual (credit) cashflows, where these can be invested in at a rate of return that meets the investor’s return objectives after allowing for default. Writing in IPE’s 2011 supplement on risk parity, investment manager AQR commented that “Risk parity should be a complement to, not a replacement for, a traditional portfolio”.

In line with that view, an ally to risk parity is an allocation to trend-following or momentum-investing styles. Several reasons explored in academic literature, mainly behavioural, account for why trends in investment markets persist. Steve Thomas and Andrew Clare of Cass Business School, in particular, showed in an August 2012 paper that a multi-asset risk-parity allocation achieves a better Sharpe ratio than equities alone, or a fixed equally-weighted allocation among asset classes, and that this can be further enhanced by applying trend and momentum rules.
 
Common criticisms

Well researched, documented and subjected to detailed scrutiny, risk parity faces valid objections that rightly identify situations in which it is not the optimal portfolio – after all, there is no free lunch – but many of its mainstream criticisms are based on misunderstandings.

Two common complaints have emerged: first, that leverage is bad; and second, that risk parity will not work if interest rates are low.

Excess leverage was certainly at the heart of the events of 2008-09 and naturally many feel it is best avoided in future. But in most implementations, risk parity does involve financial leverage. However, it is important to understand the economic equivalence of this leveraged position. A ‘conventional’ allocation to equities actually contains implicit leverage, considering a stock is usually a leveraged exposure to the underlying assets of a company.  Indeed, it can be shown that, on average, a risk-parity portfolio contains less leverage than a conventional portfolio once the implicit leverage of equities is considered.

When it does use more leverage, it does so in a dynamic way, adjusting according to market conditions.

The Japanese experience disputes the claim about risk parity and low interest rates. Over the past 15 years the yield on 10-year JGBs has remained roughly constant, but they have delivered a substantial risk-adjusted return by rolling down an upward sloping yield curve.

Further, interest rates must rise by more than suggested by the yield curve for the fixed income component to deliver a negative return.

In fact, risk-parity portfolios are at their most vulnerable to negative returns when sudden unexpected moves in underlying asset classes occur, such as the surprise Fed tightening in 1994, because there is no chance to reduce exposures.

Long-held views about portfolio construction have certainly been challenged, in the last few years. Portfolios previously thought robust have been tested and found wanting. Now, in the period of reflection, our industry is faced with a chance to reassess our engrained assumptions. As academic research has a chance to catch up with recent events, new ideas such as those discussed here, come to the fore. And, as always, detailed scrutiny of new ideas will be key, along with the ability to adapt to proven new practices rather than remaining anchored to historical ones.
 

Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer

 

In 2012, the “London Whale” trades resulted in losses of $6billion. JPMorgan were widely renowned as among the best managers of banking risk in the world, and had navigated the financial crisis far better than most; yet these losses resulted from inappropriate use of a risk model that seems not to have been fit for purpose.

There was nothing new in this. In 2007, David Viniar of Goldman Sachs famously described seeing “25 standard deviation events, several days in a row”. To put this in perspective, for a normal distribution this is equivalent to buying one ticket a day and winning the lottery every day for three weeks. In fact, a 25 standard deviation event has a probability of 10^-135, whilst the number of particles in the universe is estimated at around 10⁸⁰. The age of the universe, in days, is a paltry 10¹³.[1]

Now, Viniar was cutting his bank’s holding in US residential mortgages back in 2006, so we can assume he wasn’t fooled by the outputs of a faulty risk model. But his comments highlight how starkly unfit for purpose some models were, and many of Goldman’s rivals fared far worse in the financial crisis.

It is not hard to see why though: the world is complicated. Constructing good models is a fundamentally difficult process; so is testing them rigorously. It is imperative to have a good process in place for validating any risk model- ideally, and for important models, it should be done by an external third party, who can offer both visible objectivity and a fresh perspective on the underlying assumptions and methodologies.

Moreover, the whole regulatory landscape is changing, with the introduction of new legislation such as Basel 3, Solvency 2 and EMIR; and model risk management is a hot topic. In fact, the Federal Reserve has taken the issue sufficiently seriously that they have already issued guidelines on model risk management and model validation. These guidelines are both detailed and wide-ranging, identifying principles that apply to any user of an ALM model.


The crucial question for a model validation is ultimately this: “do you know when and how you would expect this model not to work?” To answer this question, the guidelines drill down further, and require that any model validation must address 3 key areas:
 
 1-   Conceptual Soundness- does it make sense? This includes a thorough review of the assumptions and methodologies employed, as well as the data set used; it also involves identifying where the key assumptions are useable and where they are not.
 
 2-   Outcomes analysis- do the outputs capture the behaviour seen in the real world? In principle this is simpler; in practice it may be harder (than the conceptual analysis). However, it is clearly necessary, and has the ability to reject a number of poor models with a clear rationale.
 
 3-    Ongoing monitoring- does it still make sense (the guideline is to re-evaluate the model at least once a year)? As the market changes, or as new assets and liabilities come into the portfolio, the model may no longer be fit for purpose. For example, JPMorgan’s models were appropriate for small credit positions, but the model ceased to be viable when the bank held so much of the whole CDS market. Markets change over time, so models should change as well.
 

It is important to note that model review and validation is not a purely negative process, and it can have a lot of upside potential as well. For example, consider a bank’s economic capital model for its pension scheme: a thorough review could lead not just to better risk monitoring but also to investment strategies that were more efficient with respect to Tier 2 capital. And model review is clearly a vital part of any sensible model risk management policy. A clear, simple set of recommendations on when and how to use the model, and when to stop using it, should make it far easier to avoid running sizeable hidden risks. The argument in favour is very clear.
 
So the question I put to you is this- “how has your model been validated?” Or, better yet, “do you know when and how you would expect your model not to work?”
 
 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer


 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

Had you walked through Redington’s office on any given day over the last few of months you would have seen a copy of Nassim Nicholas Taleb’s Antifragile on someone’s desk.
 

Love him or hate him, his writing certainly spurs debate – as fully evidenced by the number of iterations this co-authored article has gone through.

Taleb’s central thesis is startling, easy to grasp and delivered with the straight talking conviction of a man who eats his own cooking. Can some of Taleb’s ideas be applied to pension scheme investing? Are pension schemes fragile, robust or antifragile?

We have made an attempt to map Taleb’s key principles against an underfunded UK pension scheme’s investment strategy and how it is managed (see table) – taking the necessary unapproved artistic licence.
 

Taleb introduces his abstract theory by stating that we have no accurate antonym for the word fragile. Words such as strong or robust are only half-way houses. To truly be the opposite of fragile, it isn’t sufficient to simply withstand shocks, you also need to benefit, thrive and grow from them – you need to be antifragile.

 

Taleb goes on to explain that nature and other complex systems, such as the economy, are antifragile. But the neurotic obsession of regulators and lawmakers in depriving the economy of volatility and iatrogenic interventionism has introduced fragility into the system (remember Gordon Brown’s failed attempt to put an end to boom and bust). Shocks no longer occur in dribs and drabs, taking out the weakest for the benefit of the whole. Shocks now hit us like a sledgehammer.

 

The interdependencies present in today’s globalised economy can produce non-linear chain reactions that decrease, even eliminate, predictability. Instead, Taleb argues we should be focusing on measuring fragility, defined by the following simple heuristic: “anything that has more upside than downside from random events is antifragile” and vice versa.

 

Taking some of the characteristics he puts forward to identify fragility would imply that an over reliance on static and undiversified asset allocations (primarily consisting of two predominant risk exposures), lack of a clear game plan, unrealistic assumptions, reliance on unreliable economic forecasts, ineffective decision making and a focus on a single risk measure could cause fragility. The 2008-09 “black swan” certainly highlighted that fragility was there, resulting in significant deterioration in funding levels to most pension funds.

 

So how are these schemes becoming more robust? Taleb’s principles suggest that schemes look for greater diversification (by risk exposure not market values), prudent rather than best case assumptions (especially for equities), greater focus on monitoring key performance indicators such as their funding level (not the market level), hedging out large single exposures to risk such as sensitivity to interest rates and inflation; and not trying to call the market or predict the unpredictable (unless you’re Warren Buffet, and there’s only one of him).

 

Finally, these schemes no longer rely on a single measure of risk. Value-at-risk is clearly flawed and should not be used in isolation. Deterministic measures allows schemes to measure how fragile they are to, for example, small changes in interest rates, a 40% fall or rise in equity markets, or a repeat of the 2008 financial crisis. Taken together these risk lenses allow schemes to better determine whether they are fragile and allows them to tinker with their portfolio to try and minimise the impact another crisis might have.

 

“Sensitivity to harm from volatility is tractable, more so than forecasting the event that would cause the harm”, writes Taleb.

 

As for becoming anti-fragile, that’s not quite as simple. It demands discipline and strict adherence to a framework that will allow for effective decision making and the ability to exploit optionality as and when it presents itself. We’ve assisted a number of our clients to implement their own pension risk management framework that puts them firmly in control of their scheme. It allows them to lower the sail when market volatility presents positive outcomes – thereby building reserves against a future downturn – and be decisive enough to go full sail when the opportunity arises – positioning themselves for the upside.

 

Being antifragile calls for dynamic asset allocation and the liquidity to do so (or as Taleb put it, redundancies). Building in this liquidity is a key element of being antifragile, without which you become a super tanker trying to make a u-turn with a storm over the horizon.

Whether you agree with Taleb’s notions or not, there can be no doubt that the world

we’re living in is becoming increasingly volatile. Ensuring that you are agile enough take advantage of volatility and accepting that it is impossible to calculate the risks of a Black Swan event, or predict when they might occur, is key to survival.

 

As Taleb so eloquently puts it, “Not seeing a tsunami or an economic event coming is excusable, building something fragile to them is not.”

 

 

[Please note that all opinions expressed in this blog are the authors' own and do not constitute investment advice.  Click here for full disclaimer]

Data Source: Professor Shiller, http://www.econ.yale.edu/~shiller/

__________________________________________________________________________________________________

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer
 

 

Looking at the above charts, a number of conclusions become apparent:
 

The 7 Step Framework therefore allows the ready comparison of apparently very different asset classes along two (relatively) simple guidelines, providing a useful tool by which the entire universe of managers can be compared and contrasted to one another. Of course, we can only go so far with two survey questions, and several important issues (including how the profile of various asset classes changes over time) have had to be left out. However, as is hopefully apparent from this brief overview, if the 7 Steps offer pension schemes a useful tool to map their path to full funding, they also offer our own Manager Research Team a way to judge which opportunities are the most relevant for our clients at every point in their journey.

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

Alice: Would you tell me, please, which way I ought to go from here?
The Cat: That depends a good deal on where you want to get to.
                                                                                - Alice in Wonderland, Lewis Carroll

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer


 

Most quantitative studies agree that there were periods of time when Risk Parity lost money (to be expected in certain scenarios), and also where Risk Parity delivered a negative real return – which was the case for most assets in the face of such high inflation. Studies that include a commodity component in the Risk Parity portfolio generally conclude that the Risk Parity portfolio significantly outperforms a fixed weight portfolio over these periods of time. The commodity component’s correlation with inflation allowed this result to occur (driven largely by the US abandoning the gold standard and the resultant feedback into the commodity complex including oil and gold).

Most quantitative empirical studies that attempt to make a fair representation of real Risk Parity portfolios, agree that over long periods of time, which capture different fixed-income cycles, a Risk Parity strategy would have delivered a better risk-adjusted return than equities, or than a fixed-weight allocation between asset classes.

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer
 

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer


 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer


 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

 

I owe my buddy, Paul McGill, an apology. Fifteen years ago, we disagreed over whether or not it was acceptable for Tesco and the other supermarket big boys to muscle out small high street shops that had sold high-quality produce for several generations. I reasoned that whilst it was undeniably unfortunate for the small butcher and baker, who simply could not compete with the hyper-stores, that was simply brutal commercial reality. Tesco and Co were able to offer the consumer greater choice and better quality at lower cost through their massive purchasing power. What was wrong with that? It was a win-win for everyone, apart from the butcher and the baker.

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer


 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

Real yield:

Equities:

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer
 

New Year spells resolutions. For many, these involve a commitment to improving our health at the top of the list. Many of us look to improve our health by signing up to gyms, vowing to do more exercise that will leave us healthier, better looking and feeling better too.
 
Hello, my name is Teresa and I love fitness. At any time of the year you’ll find me circuit training outside, running to and from work, or completing survivor runs.  
 
All of these are great things to do, but it is important to remember the 80:20 ratio. Overall health comes from 80% nutrition and 20% exercise.  
 
Single-handedly, the biggest tool that helped me improve my health was tracking calories – simply monitoring the calories consumed versus calories burnt. That and the awesome mobile app Myfitnesspal (MFP). MFP is a free calorie counter, diet and exercise journal which easily allows you to track your calories and exercise.   
 
It’s simple:  
 

 - Step 2: MFP cleverly calculates the amount of daily calories for you to reach your goal, for me, 1500 calories per day with regular exercise. 
 

 
- Step 3: Enter what you eat day-to-day and try not to go over/under your total calorie allowance.  
 

 
Each day MFP tracks how many calories I’ve consumed and how many calories I have remaining until I exceed 1500 calories.  By far the best outcomes of MFP are having crystal clear goals and taking better decisions due to daily tracking and accountability.  
 
It’s so easy to improve your health when you have clear goals and easy to use technology that allows you to monitor your progress and therefore achieve success. 
 
So what does eating right have to do with pension scheme monitoring?   
 
Like MFP, tracking the progress of your scheme's investment strategy on a regular basis provides the framework and discipline to achieve goals. It also enables stakeholders to benefit from knowing exactly where they are, leaving them feeling in control and with the power to change strategy if they are heading in the wrong direction.   
 
Setting the framework is simple: 
 

 
Once you’ve set clear goals, the value of monitoring is that you can make better decisions by tracking where you are against your objectives, and by understanding the most relevant drivers. For example, by tracking my calories on a regular basis I understand the impact of choosing yoghurt over fruit.  Likewise, if a scheme regularly tracks the impact of their investment decisions, they too can choose whether investing in high yield or hedging more liabilities is the right decision for them.  By understanding scheme’s risk, stakeholders can assess investment opportunities vis-à-vis the liabilities, and assess the impact of expected returns versus required returns.  
 
Alongside good governance, monitoring enables effective action by providing a clear framework to make decisions, and by highlighting the most relevant scheme metrics. Clear goals plus easy-to-understand monitoring forms a powerful blueprint for any investment committee, CIO or fiduciary manager to follow.  

Whether your resolution is to get fit or not, a new year is an opportunity to set yourself goals in all aspects of your life including business. If your scheme doesn’t have regular monitoring, what are you waiting for? The next year is going to happen regardless, so why not think about monitoring as a means to improve your scheme’s health. Give it a shot.   


 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

When it comes to financial markets, instincts often turn out to be wrong.

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

The aim of the education day was to instil the importance of understanding and managing personal finances and also to help them realise their future is in their own hands. Subjects for this introductory session range from Goal Setting and Budgeting to Assets and Liabilities to Entrepreneurship. It’s vital that the students have fun: all teaching is interactive and much of the learning is game-oriented. For example, an activity to show the power of compounding involved the class running to each side of the room! This type of teaching not only means that the students have a good day out and a light-hearted introduction to such an important topic, but also, we believe, this is the best way to make it a memorable experience and encourage students to take away the key learning points.

If you like the idea of this scheme, we would love to have you get involved. Spread the word to parents and schools that you know, sign your children’s school up, contact us about volunteering as an educator, or ask us any questions you might have about the scheme. We’d be delighted to hear from you. 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

 

We are always on the lookout for new authors with a fresh perspective on pensions, markets and economics. If you would like to contribute to RedBlog, please drop me an email – gurjit.dehl@redington.co.uk.
 
Here’s a rundown of the 12 most viewed blogs in 2012:

1. RPI v CPI: Magic new formula will lead to shrinking wedge – Kenny Nicoll

2. World population evolution (infographic) – Dan Tracey

3. CRY! It’s a Kodak moment – Dawid Konotey-Ahulu

4. Are you an Amundsen or Scott? – Robert Gardner

5. Inflation is back for good – Anatole Kaletsky

6. PV01 and IE01: Models on models – Dan Mikulskis

7. Pessimist – Optimist – Realist – Robert Gardner

8. Chart: 30 year gilt yields break range – Gurjit Dehl

9. Splash out on an illiquid asset and get some real returns – Robert Gardner

10. Who believes in the pension fairy? – Andrew Clare

11. Pension risk management radar (infographic) – Robert Gardner

12. Ready or not, EMIR I come – Tom McCartan

 

 
 

 

The year of EMIR, it's finally here.

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer

More drama from the Office of National Statistics (ONS) today, although it’s possible you missed it. Avid followers of these things will know that pension plans have, for the last couple of years, been in a sort of limbo as regards the two leading (but crucially different) measures of inflation: Retail Price Indexation (RPI) and Consumer Price Indexation (CPI).

Back in 2010, the government announced that it had had enough of RPI generally, and preferred CPI. Because the government is the government and can do what it likes, it also announced a wholesale switch from linking pension payments to RPI, to linking pension payments to CPI. This was pretty punchy stuff because RPI is usually higher than CPI and over the long term, pensioners could reasonably expect their pensions to fall significantly. Many, therefore, regarded the proposed switch as nothing more than a cynical ploy by the government to reduce its public sector pension liabilities. The govenment protested that this view was harsh and unfair, maintaining that it was simply concerned with consistency (it uses CPI for most inflation type calculations).

As my kids say, Whatever.
 
For those who thought that was the end of it, it wasn’t. Last October, the National Statistician announced a consultation into the differences between RPI and CPI, noting that these different measures of inflation were not helpful and probably not in line with international standards. Further, it became clear, her conclusions would potentially lead to the reduction or complete elimination of the differences between the two measures, with RPI, in effect, being modified to become CPI. This harmonisation of RPI with CPI was the National Statistician's “Option 4”.
 
The potential impact (of changing RPI into CPI) on the markets, on gilts and on pension benefits (which are linked to inflation) would be significant.
 
So here’s the punch line:
 
The market was fairly certain that The (Option 4) Change would be made and that RPI would henceforth become CPI. Here’s what one leading investment bank had to say a couple of days ago:
 
“Option 1 [no change] should be ruled out. The ONS's view is clear, the independent expert Diewert’s view is clear, and there doesn’t appear to be any way to fudge the result by doing something other than the maths differently.”
 
Thus, the market had “priced in” The (Option 4) Change as though it had already happened. Or rather it had priced in a lot of The (Option 4) Change, waiting until today for the full announcement.
 
Once The (Option 4) Change happened, all inflation linked instruments would get cheaper (due to RPI (which is higher) morphing into CPI (which is lower)). Lower inflation means cheaper index linked gilts and swaps.
 
Thus many pension funds stood on the side lines waiting for The (Option 4) Change to be officially announced, so that they could buy cheaper index linked gilts and inflation swaps following the switch.
 
Today is D-Day. Guess what? The (Option 4) Change didn’t happen after all.
The National Statistician, Jil Matheson went for ........ Option 1 (NO CHANGE)!
 
Ay Caramba!
 
Here’s this morning’s ONS press release. See how Jil starts by teasing us with a gorgeous feint:
 
“Following a consultation on options for improving the Retail Prices Index (RPI), the National Statistician, Jil Matheson, has concluded that the formula used to produce the RPI does not meet international standards and recommended that a new index be published.”
 
But not so fast, amigo. Jil is leading us right up the garden path, as it turns out, for just two short paragraphs later...
 
“In developing her recommendations the National Statistician also noted that there is significant value to users in maintaining the continuity of the existing RPI’s long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations. Therefore, while the arithmetic formulation would not be chosen were ONS constructing a new price index, the National Statistician recommended that the formulae used at the elementary aggregate level in the RPI should remain unchanged.”
 
Lovely stuff.
 
The markets, wrong-footed, gasped and reacted sharply. Read this nice piece by Dan Mikulskis.
 
It just goes to show. Trying to second-guess the markets, the Regulator, the Office of National Statistics, the Board of the UK Statistics Authority, the Bank of England, the Chancellor of the Exchequer, the Consumer Prices Advisory Committee, the Treasury, The Department of Work and Pensions, Jil or the Grand National, is a mug’s game.
 
Either you have a risk management framework for your pension fund or you don’t.

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

 

In 2013 Redington launches RedSTART, a financial literacy and entrepreneurship education programme aiming to build confidence, drive and ambition in young people in London.
 

 

Why?
 

The shift from Defined Benefit (DB) to Defined Contribution (DC) pension provision represents a paradigm shift in responsibility from the corporate to the individual. The investment understanding and financial knowledge required to successfully manage one’s own pension provision is an integral part of the education of young people. Educating our young people in financial literacy is not a luxury but an imperative.

 

A growing number of commentators now foresee growing conflict, and even future political strife, over the entitlements amassed by the retired and retiring baby boomers. Younger citizens are beginning to realise that the current distribution of entitlements is unfair. This is exacerbated by demographics; the UK has an ageing population – generations Y & Z will have to support a significantly larger retired population than the generations that preceded them.

 

On the 19^th December 2012 RedSTART hosted its pilot crash course in financial literacy and entrepreneurship, welcoming a group from Lister Community School in Newham, East London to Redington’s offices. Using innovative and interactive teaching methods, ten volunteers from Redington taught 12 and 13 year old students our bespoke syllabus, which aims to capture the entrepreneurial flair of our founders Robert Gardner and Dawid Konotey-Ahulu, as well as the financial knowledge of Redington’s workforce.

 

“The students were very excited by the day, we felt very privileged to have had so much input from so many interesting members of your company. I am sure the rest of the programme will be a huge success.” Teacher, Lister Community School
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

Dear Santa,

Despite the omens of approaching a year with the number ‘13’ in it, I am hopeful for the coming year and the opportunities for pension funds. Last year I asked for Eurozone Resolution, Lower Volatility and strength for pension funds to Act on Opportunities in my letter to you. I even dropped my tennis lessons with Rafael Nadal off the list, in the hopes of those wishes coming true.

I guess you thought I wasn’t a good boy last year, though, because I didn’t really get any of the items on my list. I suppose it was a bit greedy of me to ask for all three. You did give some of the third item, though, and allowed some key pension funds to take advantage of opportunities presented to them. For that, I’m grateful.

This year, I’ve learned my lesson and my wish list is much smaller. I’ve also been very good this year so I’m hopeful that you’ll bring me what I ask. I request only a few small things:


Pension Funds Achieving their Goals with Less Risk

Pension funds have been hit so hard for the last few years. There has seemed to be no respite from quaking markets and dearth of political bad news. Thankfully, there’s a silver lining and new opportunities that give pension funds the protection they need from liability-matching, as well as the upside from growth assets, have appeared! This year, I hope for more opportunities like this for pension funds, so they can achieve their goals with less risk.


The Overhaul of GenY’s Saving Ethos (or lack thereof)

The pensions industry’s problems worsen as time marches on and the next generation fails to pay attention to the real problems. Even if we solve the problems of pensions today, we still face the abyss of the next generation’s lack of preparation and long lives. Gen Y doesn’t save, nor does it know how to invest. Why? When we are in the situation we are in now, despite auto-enrolment, why isn’t Gen Y, who will live longer and require more financial assistance, being urged and educated in the art of planning, saving and investing for retirement? This year, I wish for members of Gen Y proper financial education, and an investment solution that works for their savings. I would be happy to help with this one, you don’t have to do it all on your own.


An iPad Mini

They really are, so cool.


I really think I’ve been much better this year, please don’t penalise me for jumping off the Shard, it was in the name of charity I wasn’t just being mischievous.

Yours expectantly,

Rob Gardner, Age 34

 

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

I’ve just started reading Nate Silver’s new book The Signal and The Noise (Why so many predictions fail - but some don’t). If you’re looking for something stimulating to read over the Christmas break, this should do the trick. There’s still time to order it.
 
Nate Silver, (34), is the US’s latest media darling - he has accurately predicted the outcome of several major elections in fine detail. In the race between Barack Obama and Mitt Romney, Silver correctly predicted the winner of all 50 states and the District of Columbia. Now, that’s never been done before.
 
Here’s an extract from the introduction:
 
“In The Signal and The Noise, Nate Silver examines the world of prediction, investigating how we can distinguish a true signal from a universe of noisy, ever–increasing, data. Many predictions fail, often at great cost to society, because most of us have a poor understanding of probability and uncertainty. We are wired to detect a signal, and we mistake more confident predictions for more accurate ones. But overconfidence is often the reason for failure.”
 
So, Silver’s book has got me thinking about our own industry, and the confident predictions that have been made over the last ten years, specifically about the market factors that drive the level of pension scheme deficits. On the whole, I think I can say without fear of contradiction, those predictions have been spectacularly wrong. For the last decade, there has been a general consensus that equities would undoubtedly return 7% year on year, the real yield would rise and peace on earth would be restored.
 
Anyway, here is my Market Diary blog written seven years ago which my buddy and Co-CEO Rob reminded me of a couple of days ago.


 

 

You will realise that back in 2005, we were flying directly into a forecaster's head-wind with the “fanciful” prediction that we would soon see a super-low real yield of 0.17% and, consequently, soaring pension deficits. The general consensus back then, was that the real yield would rise, not fall.
 
Our predictive reasoning, for what it is worth, wasn't complicated:
 
The immutable laws of supply and demand are at work. They grind exceeding slow, but exceeding sure. There aren’t sufficient index-linked gilts or swaps for every pension scheme’s needs. As demand goes up, (due to regulation, accounting and too many other factors to go into here), the price will surely rise and the yield will surely fall. This will keep happening for a long time to come. Eventually there will be no real yield at all. Devastation and misery will follow.


 

 

I explained it all to my six-year old son:

There are only three bars of chocolate left in the sweets shop. The nice man who owns the shop can put up the price of the chocolate bars whenever he wants to. If all the kids in your class go into the shop and ask for a bar of chocolate, what will the nice man do?
 
He will put the price up, Papa.

Then what?

I won't be able to buy any.
 
Atta Boy!
 
To tell the truth, things didn’t move as quickly as we expected. Although the real yield did eventually collapse, it took another four years to fall to 0.17%. When it did, it blew straight through to zero and below. These days, it hovers somewhere around freezing.

 

 

On FTSE, we were out by 9 months. In September 2008 it fell to 4850.
 
Footnote: As my boy observed back in 2005:

Maybe we should go to the shop right now and buy some chocolate before the man puts the price up...?

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

 

 

“….. the investment of the assets in such a way that the existing business is immune to a general change in the rate of interest”

Frank Redington - Journal of the Institute of Actuaries 1952


The liabilities of a pension fund suffer three main risks: interest rate risk, inflation risk, and longevity risk. If interest rates fall, inflation rises, or people live longer, the liabilities of a fund increase significantly.

The LDI hub for a pension fund trying to make full funding has three core roles:

    1. First, it gives the pension fund the ability to use a large toolkit of instruments, including bonds (gilts) and derivatives (swaps) to hedge these risks.

    2. Second, the LDI hub allows the pension fund to manage its collateral (cash and gilts), which will become increasingly important in 2013 as pension funds start moving to central clearing. [SeeTom’s blog - READY OR NOT, EMIR I COME]

    3. Finally, the LDI hub can be used to implement other derivative overlay strategies in the portfolio. For example, a pension fund could synthetically gain exposure to an equity market using an equity future on the S&P500 or a buy put option on the FTSE100 , as a way to gain or in order to protect the downside of their UK equity portfolio.

The role of the LDI hub should be separate from the timing of transactions, and regarded as an ongoing risk management toolkit – not a short-term de-risking task.

For most pension funds the largest risks to the funding level, unless they have been hedged, are interest rate and inflation risk arising from the liabilities. A sharp reduction in risk can be achieved by increasing the hedge ratio: the ratio of interest rate and inflation sensitive assets relative the interest rate and inflation sensitivity of the liabilities. A pension fund that is 80% funded with a traditional 65% equities and 35% fixed income benchmark might only have a hedge ratio of around 20%. In order to immunise the funding ratio to changes in interest rates and inflation, this ratio must be increased to 80%, the risk-neutral hedge ratio. If a pension fund’s goal is to immunise the absolute deficit, then the hedge ratio needs to be increased to 100%. Over the last decade, LDI has become widely adopted with over 600 LDI managers mandated and over £300 billion in assets under management by LDI fund managers (2012 KPMG LDI survey). However, today’s environment is one of low level nominal rates and real yields. The challenge, then, is fitting a view on rates, inflation and real yields against a risk budget and the impact of calling the markets wrong.


“In a strict sense, there wasn’t any risk – if the world had behaved as it did in the past”
Merton Miller - Economist & Nobel Laureate on the demise of Long Term Capital Management


If a Pensions Risk Management Framework (PRMF) document has been laid out thoughtfully, it will encompass all the instructions an LDI manager needs to implement an effective strategy: timing, choice of when and what to hedge, and at what market or funding levels. It will be driven by the goals, objectives and risk budget set out in the framework. An LDI hedging framework for a traditional pension fund might include a disciplined, averaging-in approach over ten years. For example, this may involve increasing the hedge ratio by 6% a year, from 20%, to reach an 80% hedge ratio in ten years’ time. In combination with Step 7, monitoring, the LDI Hub that is informed by the PRMF can be built into a dynamic de-risking strategy, one that allows the dynamic increase of the liability hedge ratio via the LDI hub. Using this technique, it would be possible to move faster in the event of sharp rise in real yields to capture the increase in funding ratio, and to capture the outperformance of the assets against the liabilities. A pension fund, for example, could effect the dynamic switching from equities to increasing the hedge ratio via the LDI hub. Within a well designed PRMF, this strategy could allow re-risking to occur when the PRMF and conditions call for it: a pension fund could, for example, add more equity exposure using equity futures or total return swaps. This dynamic approach can also be applied to other parts of the strategic asset allocation, for example, by switching from shorter dated credit risk premia to longer dated and often illiquid credit risk premia in order to lock-in the re-investment risk needed to fund the plan. See steps 4 and 5.

Like a skilled sailor, the pension fund will always have a clearly defined goal, but will adapt with the seas to achieve it.

Action

“They always say time changes things, but you actually have to change them yourself”
Andy Warhol


1. If you do not have an LDI hub in place, which may be because you believe rates are extremely low and will likely rise again, I recommend researching and appointing one anyway. That way, you can put in place a dynamic risk management framework that is able to take action when the opportunities arise.

“Markets can remain irrational longer than you can remain solvent.”
John Maynard Keynes


2. If you have an LDI hub in place, review it to make sure the LDI manager has access to the broadest possible toolkit of instruments but is also constrained by a carefully considered and appropriate Investment Management Agreement (IMA). Be prepared for central clearing.

 
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

 

Dick Fosbury commented on the High Jump Final in Mexico 1968 “I guess it did look kind of weird at first,” he said, “but it felt so natural that, like all good ideas, you just wonder why no one had thought of it before me.”

Liability Driven Investing “LDI” is to pension fund asset allocation and risk management what the “Fosbury Flop” is to High Jump. Mexico Olympics 1968: Richard Douglas “Dick” Fosbury (born March 6, 1947) introduced a revolutionary approach to High Jump which resulted in his winning a Gold Medal and setting a new Olympic Record at 2.24 meters (7 feet 4.25 inches). His then new and unique “back-first” technique, now known as the Fosbury Flop, is adopted by almost all high jumpers today. During the 1960s there were several high jump techniques, the scissor kick, western roll and the straddle, but Fosbury’s technique was to sprint diagonally towards the bar, then curve and leap backwards over it. The standing Olympic record before Fosbury introduced his Flop was 2.18m, held by Valeriy Brumel, who used the straight-leg straddle technique to win the Tokyo 1964 Olympics.

As a young boy, Dick Fosbury was taught both the western roll and the scissors style. In a 2008 interview with Simon Burnton of the Guardian, he said “In the very next meet, as I was attempting a new personal best, I felt I had to do something different to clear the bar and I tried lifting my hips, which caused my shoulders to go back, and I succeeded. I made a new height, I tried again, and successively I was able to clear six inches higher than my previous best, and that change made me competitive, it kept me in the game, and I converted from sitting on the bar to laying flat on my back.”

In 1965 he got a scholarship to Oregon State University where he continued to work with his coach Berny Wagner. But Wagner was no fan of the flop, which he considered “a shortcut to mediocrity”. However, one day in the summer of 1966, Wagner decided to capture the flop on video for posterity. He set the bar at 6ft 6in, and filmed Fosbury sailing over it. Reviewing the footage, he realised that his pupil had cleared the bar by a good six inches. “That,” he said, “was when I first thought he was going to be a high jumper.” But Fosbury was still a long way from being an Olympic champion. By 1967 he had risen to a world ranking of 61, but even by the time of the Olympic trials, held a month before the Games began, he was not considered a likely medallist.

At the Mexico 1968 Olympic Games high jump final the bar started at 2m (6ft 6in). With his revolutionary technique, Fosbury had made four successive jumps easily sailing over the bar at 2.18m. From 61^st in the world going in, he was now guaranteed a medal alongside his fellow American Ed Caruthers, and the Soviet Valentin Gavrilov. The fifth high jump at 2.20m was cleared by all three athletes, but on the sixth jump, Gavrilov failed at 2.22m.This left Fosbury and Caruthers fighting for gold. Fosbury had not missed a single jump in the competition, though, whilst Caruthers had failed five times. The sixth high jump bar was then set at 2.24m (7ft 4in), a new Olympic record height. Fosbury with his longer run-up and lengthier preparation sailed over the 2.24m bar. But Caruthers failed in his attempt. History was made when Dick Fosbury became Olympic Gold Medallist with a revolutionary new and superior approach to high jump.

Fosbury’s innovation, though, was not immediately embraced by high jump athletes. Four years later, in the 1972 Munich Olympic Games, twenty eight of the forty competitors used Fosbury’s technique, but Juri Tarmak of the Soviet Union won Gold using the straddle technique. Since then, though, all Olympic medals in this discipline have been won using the Fosbury Flop. Today it is by far the most popular technique in modern high jumping.

Mexico 1968 high Jump Final (Fosbury 2.24m Ed charuters 2.22m)




Why? There were several high-jump techniques: scissors, western roll and straddle. All attacked the bar from the side or face on and all use the inner foot to take off. Conversely, in the Fosbury flop, the athlete runs up in a curve, jumps by taking off from their outer foot and twists their body to clear the bar with their back. They finish the movement by lifting their legs over the bar and landing on a mattress. The back-first jump offers many improvements compared to traditional techniques: the curved run-up allows the high-jumper to reach the bar with more speed and to do a more powerful jump. The body arches over the bar and the centre of gravity is underneath, which is an indisputable mechanical advantage. In just one Olympic Games, Dick Fosbury excelled by revolutionising the high jump discipline, making his mark on both the history of athletics and the entire future of the sport.

Friends Provident swaps away pensions risk

On the 3^rd December 2003 the Friends Provident Pension Fund made history by implementing a brand new technique to manage the long-term health of the Fund. The UK life assurance company implemented derivatives to hedge out its pension fund liabilities against interest rate and inflation risk.

Following the analysis by Dawid Konotey-Ahulu and the Merrill Lynch RedAlpha team, Friends Provident designed and implemented a far more effective solution for ensuring the pension fund’s long-term strength than the cash flow or asset mixes that other companies were focusing on at the time. According to Graham Aslet, the Company Appointed Actuary, the question you should be asking yourself is not whether to use bonds, like Boots a few years earlier, or equity, like most pension funds, but how big your swap should be. Like Dick Fosbury, Graham Aslet and Friends Provident were looking for a revolutionary approach to achieve success. A year later Graham Aslet said in an interview “I don’t think we had previously considered that route because of the slight stigma that is still attached to the use of derivatives. The necessary hedging involved in life assurance is one thing, but having to convince naturally conservative trustees of their use and safety is another.”

Why would you voluntarily run £1 million a basis point of risk in your pension fund?

Although the technique was new for pension funds it was not new for corporates. Dawid Konotey-Ahulu, then Managing Director of the Merrill Lynch Insurance & Pensions Solutions Group, argued that, if a fund has the same status as a corporate bond, it is odd that companies are happy to run risks in their pension fund that they would never dream of running within the rest of the company. He said in a press interview “Almost every major issuer of international debt covers itself against currency and interest rate risk, taking out derivatives to switch its exposure from fixed to floating rates, but not one covers itself against pension fund risk”. That risk is derived from a pension fund’s real yield, which is determined by nominal interest rates and long-term inflation expectations. A good proxy for UK pension fund yields is the yield on the gilt, shown in the chart below. As it shows, the real yield on the 2035 index-linked gilt has fallen from 2.12% to 1.52% in the space of a year. If a company had a £500 million pension fund, that 60bp fall in real yield would result in a fall in the value of the fund of £60 million. It would be a disastrous equity market that produced that scale of damage for a fund in the space of a year.

Using Liability Driven Investing using swaps to hedge the liabilities, not equities or bonds, is the answer

Many companies had begun to recognise the problem. But their answer was either to concentrate on getting the maximum return from the equities that make up their pension fund, or to cashflow match using bonds to extend the income from their assets out to a predictable amount over 20 or 25 years. But equities were not the answer: the European markets had risen in 2003 and 2004, but despite that, pension fund deficits still relentlessly rose. Neither are longer-dated bonds the solution: the risk to a fund from real interest rates is at 60, 70 or 80 years in the future. Buying bonds that expire in 25 years will not help. At the time, the 30 year Index-Linked Gilt was the longest duration bond. UK retailer Boots is a good example of a company that bought bonds in order to try and cash-flow match, but reverted to equity when the bonds failed to solve its dilemma.
 

Chart showing the LDI swaps hedge mark-to-market value versus the Real Yield

Source: Merrill Lynch RedAlpha 2005
 

The reason for the rise in pension fund deficits despite improving equity markets in 2003 and 2004 was because the size of the liabilities had risen by more than the rise in equity markets. Furthermore, because most pension funds were underfunded, i.e. their assets were less than their liabilities, the real yield volatility impacted 100% of the liabilities which might be 25% greater than the asset value of the pension fund. Dawid commented at the time that “A lot of companies understand that interest rates and inflation are hurting the pension fund; what they don’t understand is the detail of how and where. They need a strategy to immunize the volatility in the liabilities: an asset whose value moves in the opposite direction to the liability and which they can tailor to match their specific sensitivities,”.

The use of swaps by pension funds was novel as, on day one, the swaps began with a value of zero. Their value then alters as inflation or interest rates change. The key for pension funds is to design a portfolio of swaps that mirrors the mark-to-market change in the value of the liabilities. Interestingly, this concept was known as duration matching, and was originally proposed by the Life Actuary Frank Redington in the mid 1950s. The only difference with this modern approach is that the duration matching tool was an interest rate swap and an inflation swap.

One reason many other pension funds at the time would not consider hedging using swaps was that they believed wholeheartedly real interest rates were as low as they were going to go. It was quite a risk to take, to try and call the market when you could be losing £1 million for every basis point the real yield falls. In an interview in 2004 Dawid said “A year ago lots of companies looked at the real yield at 2.15% and said it was at historic lows. One or two even took the view that it would be impossible for the real yield to fall below 2% and therefore decided not to hedge. But it fell to 1.9%, 1.7% and it’s now at 1.5%. Given that you really have to say there is a chance the real yield could fall a lot further”. What’s more, the nature of interest rate yield curves is that it is negatively convex: the lower the yield gets, the greater the proportionate cost of each basis point drop. A pension fund’s sensitivity may be £1 million a basis point now, but if interest rates fall another percentage point that sensitivity would rise to £1.4million. Sadly, this is what has happened to many pension funds since then. A year after the Friends Provident transaction, when asked why more pension funds had not adopted this new approach, Aslet said the idea of derivatives may be a stumbling block for some companies: “Our in-house expertise on derivatives and our asset management business helped to convince the trustees that we knew what we were doing”. If that psychological barrier could be overcome, he thought the same structure could be used by any company with a large pension fund.

What is strange is that, in 1968, Fosbury’s technique looked weird and new. People were cautious. But Fosbury’s innovation and guts to pursue it paid off for him, and for the early adopters that came after him, in the form of Olympic medals. Anyone watching the London Olympic 2012 would have thought it weird to see anyone attempt the high jump without using the Fosbury Flop. Watch the clip from the London 2012 Olympic Games Men’s High Jump Final, 7^th August 2012. Ivan Ukhov (Russian Federation) wins the gold medal with a 2.38m High Jump. Erik Kynard (United States) takes silver with 2.33m. Mutaz Essa Barshim (Qatar), and Robert Grabarz (Great Britain), have a three-way tie for bronze at a height of 2.29m. They all use the Fosbury Flop.

Athletics Men’s High Jump Final – London 2012 Olympic Games Highlights




Similarly, in 2012, the LDI technique has become widely adopted with over 600 LDI mandates representing over £300 billion of LDI assets (source KPMG 2012). Despite the general appetite to reduce risk in pension funds, many made the call that real yields couldn’t fall any lower. Sadly they did. However, this represents a small proportion of UK pension fund liabilities. Pension funds will consider a buy-in or buy-out where the principal risk management tool used by the insurance company is LDI, but will often not consider LDI as part of their pension fund asset allocation and risk management framework. Why? Is it because they are still wary of the still relatively new LDI technique, or is it a belief that rates will mean-revert to higher levels?

Mexico 1968 Citius! Fortius!

Fosbury’s new Olympic record took its place in an Olympic Games that saw many new world and Olympic records: indeed, in the long jump, America’s Bob Beamon jumped an incredible 8.90m, a record that went on to stand for 22 years! His compatriot James Hines was the first man to run 100 metres in under 10 seconds (9.9). Tommie Smith, broke the men’s 200 metres world record (19.8 seconds); Lee Evans, that of the 400 metres (43.8 seconds); and Britain’s David Hemery that of the 400 metres hurdles with 48.1 seconds!

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

 

Nine years ago today, Paul Cooper, actuary, and true visionary pioneer, implemented a brave and hugely effective derivatives transaction which saved his firm’s pension scheme (the Friends Provident Pension Scheme) an enormous amount of money and future hassle.

Back then, I was working at Merrill Lynch, the investment bank, and, with Paul, we had been fine-tuning the details of the transaction for several months.
 
It was an extraordinary and significant day which, in the end, almost didn’t happen. Late in the afternoon, the day before we were due to execute the transaction, Paul rang me; he was having last-minute doubts. He was concerned that, as far as we knew, no pension scheme had ever attempted to hedge all its interest rate and inflation risk using an interest rate swap combined with an inflation swap of this size and enormous duration.
 
Even more worrying, there was a significant chance that the scenario against which the pension scheme was about to protect itself, would not actually come to pass. The doomsday scenario of low interest rates and high inflation expectations was, very possibly, a phantom threat that would simply never materialize.
 
For those (valid) reasons, Paul was calling me to say he was minded not to go ahead.

Remember, in December 2003, interest rates were already close to historic lows. In his pre-budget report statement to the House of Commons, Chancellor Gordon Brown said:
 
“interest rates are at their lowest since 1955”

(and went on to make a whole lot of reassuring economic predictions that turned out to be hopelessly inaccurate (as we all found out)).

So, in 2003, the chance that interest rates would fall further, was universally considered to be remote in the extreme. And the likelihood of inflation rising as interest rates fell, was felt by many, to be an absurd notion that flew in the face of all modern economic theory. It was, as one FTSE 100 finance director informed me after reading an article I had written, “the stuff of fantasy”. Nice try, no cigar, I seem to recall was his parting shot.
 
Paul, then, was phoning to run through the arguments, for and against, one more time.
 
I grabbed our legendary ALM (assets and liability management) structurer, Philip Rose, and we nabbed a side room, away from the trading floor, and overlooking King Edward Street. I closed the door and, on the phone, we talked Paul through the rationale for the hedging transaction step by methodical step.
 
Yes, we admitted, this would be an industry first. Although a few pension plans had partially hedged their inflation linked and long dated liabilities by replicating a bond portfolio using derivatives, (and, indeed, a couple of years earlier, the Boots Pension Scheme had sold all its equities and bought long dated bonds), this transaction was of a different scale and ambition. We were planning to use super-long-duration derivatives to eliminate fully the pension plan’s exposure to falling interest rates and rising inflation. This was something even the Boots Pension Scheme had not been able to achieve with its groundbreaking 100% allocation to bonds, since it had been unable to buy bonds of sufficient duration.
 
So, this derivatives transaction was seriously radical Baumgartneresque stuff, and I could fully understand why Paul was having last-minute reservations.

But, I explained, the sheer size of the naked market risk being run by Friends Provident Pension Scheme (and, truth be told, every other defined benefit pension scheme in Christendom) was off the charts. It dwarfed all its other risks. In my view, there was an imminent prospect of lower interest rates combining with higher inflation to produce a super-low real yield that would cripple every un-hedged pension scheme.
 
Over the previous century, the real yield had, on average, been significantly lower than it was in 2003. It was a mistake to think it could not go lower. Besides, corporate accounting standards had recently been tightened, and would oblige pension funds to hedge this risk (falling real yields) eventually - either willingly, or kicking and screaming - but they were going to have to hedge. As they did so, the price of those hedges would rise due to limited supply and increasing demand. And as that price rose, so the real yield offered by those hedges (mainly gilts and swaps) would fall (a higher price means a lower yield).
 
Put another way, the real yield was all set to decline rapidly and severely. At the very least, this scenario was a real and present threat. And, I went on, if the real yield did fall, those pension plans that had not hedged, would ultimately find themselves in a world of pain, as the mark to market value of their liabilities escalated to the edge of Space. No asset would be able to keep pace.
 
There was a long silence. I could tell that his decision was finely balanced. He was within a hair’s breadth of calling the transaction off, which would have been an understandable decision. He was under immense pressure to make the right call. I told him the decision was his - we certainly weren’t able to make any definitive predictions about the direction of interest rates or inflation. However, I said, in my view he had a unique opportunity to stand out from the crowd and be the first to make his move. Yes, the real yield was low at 2.13%, but that would probably appear ridiculously high, just a few years hence.
 
Paul, Phil and I had talked for over an hour and, eventually, Paul agreed that it made sense to hedge - not because he was convinced the real yield would fall, but, rather, because he recognised that this entire thing was about risk management. And it was his job to manage risk. In the end, it was as simple as that.
 
The next morning, at 11:00 on 2 December 2003, I ran through the minutiae of the transaction details with Paul: it involved purchasing a £600 million, thirty-year, compounding, zero coupon interest rate and inflation swap transaction, by which means Friends Provident Pension Scheme transferred its entire market-related liability risks to Merrill Lynch.
 
It was a team effort. Whilst I was executing the transaction directly with Paul on the phone, Robert Gardner and Phil Rose were checking and monitoring a multitude of market levels and speaking constantly to our inflation swaps trader and co-pilot, Jonathan Mitchell. Jonny’s job was to hedge the bank’s huge open position in the market immediately after execution. Coming up to Christmas, the market was thin and patchy. That makes long dated swaps extra volatile, and large trades are hard to execute. A bit like trying to land a 747 in a newly ploughed field. To say he did an amazing job would be an understatement.
 
Paul Cooper and his boss, Graham Aslet, along with the pension plan trustees and their advisers at Towers Perrin, as well as the board of Friends Provident, had made history. Over the previous two years I had presented the hedging transaction to well over 100 pension funds and corporations but only these guys had been forward thinking enough to actually do it. It was no mean feat on their part.
 
In the following weeks, the real yield began its steady, terrifying, eight year descent to 0% and below.
 

 

As it did so, the mark to market value of all defined benefit pension schemes’ liabilities soared, and, in the case of Friends Provident, the swaps which Paul Cooper had bought for the scheme, also soared - in equal and opposite value. It was awesome to behold.
 
The swaps were collateralized - which just means that as the value of the pension scheme’s new hedging swaps rose, Merrill Lynch (as counter-party to the scheme) was obliged to pledge and transfer cash and bonds of equal value, by way of security. At one point, shortly after we did the transaction, the real yield was falling so fast, and we were pledging so much collateral each day, that a guy in the Collateral Department called me at my desk:
 
We’ve never had to post this much collateral so regularly on any transaction before, he said. The swaps are rising [in value] by a million pounds every day. Is this really how it is supposed to work?
 
Yep, I replied, this is exactly how it is supposed to work. It’s a beautiful thing. And that’s why, one day, people in the know will talk about Mr. Paul Cooper and his gutsy decision to go against all popular opinion to the contrary; to fully hedge his pension scheme’s liabilities at a time when the real yield was already low. That’s what makes him an all-action actuarial hero.
 
The guy in the Collateral Department sounded bemused.
 
I guess we’ll be hearing more about this guy, then? he said.
 
I guess you will, I replied.

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]


 

In the last few months I have heard a few people mention cross-gamma risk and how this is impacting swaps transacted as part of an LDI strategy. And so I thought what better way to spend a Saturday night than with a glass of white wine, a bowl of popcorn and writing about why your swaps have cross-gamma risk. Oh, and no harm having the snooker on in the background since it's looking like the Rocket is in fine form.

Many of you will be familiar with the concepts of duration and convexity and how they apply to bonds. Duration (or more specifically modified duration), we are told, is a handy measure for calculating by how much the value of your bond will increase in response to a 1% fall in yields. Of course, we are then told that, unfortunately, this handy rule of thumb works best for small changes in yield and that for larger changes in yield the actual change in the value of your bond will be different to that implied by the bond's duration. This is because it turns out that duration, far from being a single static number, is actually a dynamic number and one that will be different depending on the level of prevailing yields. And so, to our first rule of thumb we must add a second rule of thumb:

 

 

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

Figure 1: Model IE01 of L-RPI[0,3] and L-CPI[0,3] swaps, expressed as a percentage of the IE01 of the corresponding RPI or CPI swap

Source: Underlying LPI curves, RBS; Calculations, Redington

Figure 2: pricing basis of L-CPI[0,3] relative to CPI, two different calculation methods
(Detail on methods below)

Source: Data, RBS; Calculations, Redington

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

Removing randomness, the long view and accepting the random walk
 
The vast majority of defined benefit (DB) pension schemes are fortunate that a large proportion of their liabilities fall due far out in the future. While it is crucial to know and understand the current position, trustees should be predominantly concerned with being able to pay all of the scheme’s future liabilities and subsequently close up shop when there are no more members left to pay.

Chasing short-term returns and over-obsessing with outperformance by trying to outsmart the markets should not be a key concern for trustees; instead, trustees should take full advantage of the fact that they can let time do its job, in the knowledge that:
 
1. There are no free lunches while investing: if you construct an asset allocation providing dream-like expected returns, these returns are likely to remain a dream.

Any rational fund manager who believed that he could continuously outperform the market would invest his own money rather than charge for managing clients’ investments. Hence, as long as fund managers are creatures of reason, any manager who can generate market outperformance has probably already exited the business. There is only one lesson to be learnt here:
 
2. With some notable exceptions explained below, active fund management rarely provides value for money on a cost-adjusted basis. Therefore, there will always be incentives to innovate and develop new investment products to sell.
 

The past: LDI and why it is now simple
 
Over the past couple of years, the big thing has been liability driven investment (LDI). Simply put, LDI is investing in assets that move in unison with the liabilities of a pension scheme. There are clever ways of doing this using swaps and various hedging and leveraging techniques. However, let’s not frighten ourselves just yet.
 
The concept of LDI can seem perplexing at times and while it is true that the day-to-day running of such investments can be complicated, there are some very skilled fund managers at hand with the appropriate systems and governance structures in place to provide this service to pension schemes.
 
The first holistic LDI solution for a FTSE100 company was implemented back in 2003 (by our smart friends and colleagues who later went on to found Redington), so LDI has been around in various forms for longer than many think. Building a perfect LDI strategy is no easy venture, but these days hardly a month goes by without a new user-friendly LDI solution being introduced by a large fund management house.
 
Often, we hear trustees asking if now is actually a wise time to use LDI to reduce exposure to interest rates and inflation. As we have argued in previous articles, we believe there is little point in trying to second guess movements in inflation and interest rates. These factors are highly dependent on monetary policy and political factors, and historically professional investors have failed miserably when trying to foresee these movements. Prior to implementing an LDI strategy we believe the following questions should be considered:
 

 
The present: yes we can (use LDI)
 
Initially some trustees would perhaps not answer yes to both questions, but the answer depends on one’s perspective; we would argue that in fact the answer for many schemes would indeed be yes. The average UK DB pension scheme at the end of August 2012 was around 80% funded on a S179 (Pension Protection Fund, PPF) basis and the average maturity of a UK DB scheme is, according to the PPF, around 20 years. A scheme with a medium strength covenant, a recovery plan in place and, give or take, 20 years until maturity does not need to target aggressive asset outperformance and pray for a mean reversion of interest rates to be able to pay pensioners fully, in a timely manner. Furthermore, if no action is taken interest rates could, in an adverse but not unimaginable scenario, creep down to even lower levels and eventually cripple a DB scheme’s ability to fulfil its obligations.
 
So we feel it is simple: most schemes should implement some sort of LDI strategy. While building up a perfect hedge is very costly and difficult there are now several pooled solutions that can provide a sufficient hedge and thus reduce trustees’ night-time worries.
 
One could also argue that by hedging out exposure to inflation and interest rates a scheme sponsor would also know, with much greater certainty, how much money it needs to put into the scheme going forward. Consequently, the risk for unpleasant surprises that could ultimately drive the sponsor into insolvency would diminish and the sponsor could more accurately estimate the future costs of running the DB scheme. The conclusion we can draw from this is:
 
3. LDI strategies might seem complicated. However, they are merely a tool that can be used to make your asset movements mimic the movements of your liabilities. LDI is not a new innovation that trustees should view suspiciously; it is rather a conventional (although operationally advanced) instrument to be put in the asset allocation toolbox. Furthermore, LDI can facilitate financial planning and leave room to focus on meeting the scheme’s goal (such as reaching full funding via returns generated from the scheme’s growth asset portfolio).
 
The future: final frontiers, something else or back to basics
 
In 2001 Jim O’Neill coined the term ‘BRICs’. He had noticed that these markets cover a quarter of the land on earth, accounted for 40% of the world’s population and had reached a phase in their development where he expected rapid industrialisation; consequently he expected good future investment returns in these markets. Since then, many investors have allocated funds to BRIC markets and reaped diversification benefits and strong returns owing to the rapid growth of these economies. However, as these markets have matured and successively integrated with more developed economies, returns have become more correlated with developed market returns (it is hardly a stretch to argue that it will be bad for China’s companies if the largest importer of Chinese goods, the US, experiences a slowdown in the economy). Therefore investors will have to look harder to achieve the diversification benefits they could once achieve by investing in BRICs or similar markets.
 
Several industry experts, including Jim O’Neill and Francesc Balcells, have predicted that the next big thing for investments could be frontier markets. These comprise around 30 economies that have stock markets but, owing to their size, relative immaturity or political situation, do not yet qualify as emerging markets. These include sub-Saharan economies, some Eastern European economies, Qatar, Kuwait and UAE. Some of these markets have performed rather well at times when developed markets and BRICs have been underperforming and could thus provide returns, as well as diversification benefits, at times when more developed markets seem to be struggling.
 
As a pension fund generally enjoys a very long investment horizon, there may be a case for deciding to accept some additional liquidity risk from a smaller frontier market, in the hope of enjoying the extra return and diversification benefits that come with investing in these countries.
 
While developed economies are generally considered to be relatively efficient, information in frontier markets will be scarcer and, therefore, investors with more accurate information will have a larger chance to outperform. If one considers accepting some political risk in exchange for extra return, it would also seem reasonable to have expert assistance to evaluate whether this is accurately reflected in the expected return. So it would seem logical that:

4. If a market or asset class seems to be less efficient, there might be a potential for adding value by using active management, even on a cost adjusted basis.
 
The veil of ignorance: is the next big thing really what the industry needs?
 
One could argue that it is in the nature of consultancies and fund managers to come up with fancy new solutions to solve the problems of the UK DB pension schemes. While we would like to think it is all about trouble shooting and finding the best solutions to cure the problems of the DB industry, we would also argue that what is needed is not the new next big thing and constant tinkering with the asset allocation of pension schemes, but rather:
 
5. Making full use of the long investment horizon, not praying for miracles (outside of the religious texts, they rarely happen) and not trying to achieve outperformance by constant tweaking or by applying quick fixes.
 
There are many talented fund managers providing effective and relatively simple solutions to difficult problems (for example, removing undesired risks through LDI) and consultancies tirelessly working in the best interests of the clients (providing long-term investment strategies, performance monitoring etc.). However, what this industry needs is not more quick fixes and fancy solutions; time is still on our side. In an ideal world we would use a stylised ‘veil of ignorance’ to come up with pragmatic, vested interest free, long-term approach to pension scheme investment and asset allocation. But as this is hardly possible, this author instead would suggest that trustees consider the following:
 
6. If someone comes up with a new fancy investment strategy or asset allocation that seems too good to be true, then it probably is.

Learning outcomes
 
Staying ahead of the curve, taking advantage of new innovation and following industry developments is key, not only in pensions, but in every industry. There are many brilliant professionals working in our sector, who can help make the life of trustees significantly easier. We recommend that trustees make full use of these to overcome problems and facilitate difficult decisions. However, most of the time, good investing will simply be considering all the available options, taking an appropriate level of risk, and letting time do its job; above all else, set a long term plan and stick with it.
 
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

History therefore suggests that a low interest rate environment is not conducive to high equity returns, at least in the short run. Very low interest rates are a sign that the economy is in crisis mode, that central banks have been easing monetary policy to avert disaster and that companies are not looking to invest (which would lead to higher interest rates as it increases demand for capital) because they cannot be sure that their investments will be profitable in a volatile, low-growth environment.

Of course, one could argue that by focussing on one-year returns we are missing out the bigger, longer-term return picture. A negative real yield environment may be an excellent opportunity to invest into equities because they provide attractive returns over the next five or even ten years. However, some statistical analysis shows that there does not seem to be a significant link between the yields prevailing in a given year and cumulative real equity returns over the next five or ten years. In other words, the chance to earn high equity returns in the longer run if one buys shares in a low interest rate environment is pretty much the same as the chance of heads coming up in a coin toss. Whilst statistically ‘fair’, this is perhaps not the sort of probability on which one wants to base an investment strategy.

The analysis implies that equity investors may want to brace themselves for disappointing stock market returns in the short term despite record low interest rates. More worryingly, it also means that pension funds which are underfunded should not blindly hope that stellar equity outperformance will help them to improve their funding levels quickly.

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

A Young Person’s View towards Pensions
by Anya Ratnavel, first year student at Oxford University

Saving for Retirement: The Rationale of a Young Person
by Vivek Rajpara, A-level student at Wyggeston & Queen I College in Leicsester

 

A friend of mine, who I'll call "Dave" (because that was his name) said he would do anything to avoid A-level revision. At one point he infamously found himself weighing the cat, convinced that he would only be able to settle down to work if he had that data to hand. As a result, some 25 years later, the act of procrastination is referred to by my family as "weighing the cat".

Ian Whitten, Sittingbourne, Kent (BBC Readers’ tales of epic time wasting)

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The Thief of Time

Procrastination is a curious thing. Whilst some people get things done straight away, others are serial offenders and never do anything today that they can put off to some far better time in the future:

We should so get married - just not now.

Why complete your tax return today? Today's not so good. You will be well up for it tomorrow.

Quit your dead end job and follow your entrepreneurial dream? Next year - for sure.

Planning for retirement? Probably best to start that when the kids have left home (you just never know) and the loft conversion is done.

Write a great blog while it’s fresh in your mind? Next week is better.

So, procrastination is an accomplished thief.  You believe you have plenty of time, but just when you need it, it's gone - stolen by a practised and dextrous artiste - you. And as you leave "it" longer, it becomes exponentially harder to get "it" done. Leave it long enough, and the “cost” of getting "it" done, starts to rise.

Welcome to the concept of theta.

Theta

Imagine you buy a one year put option to protect yourself against a fall in the value of your equities portfolio. After purchase, the value of your put option decreases by a certain amount each day that passes (since there is less time within which you can receive a pay-out). You can quantify this daily loss. In the markets, this erosion of value (or "time decay") through the passage of time is known as “theta”. The higher the theta, the more you lose each day that goes by.

An options trader watches theta very closely, since simply owning the option loses the trader good money every day. Here’s a graph to show how theta rises and the value of an owned option falls as time passes.

 

This is how the value of an option decays with time

Note also that as the option gets close to its expiry date, theta soars and the option loses value exponentially.

That’s theta. Passing time costs you money!

Procrastination has theta – lots of it; sometimes the theta associated with putting off an activity is measurable in pounds or dollars, sometimes not. Often the cost is relational but it’s just as much a cost.

Relational Theta - if you will:

“Honey, I’m sorry I can’t make Jack’s birthday party at school this afternoon – I have to finish a presentation for the board.”

“You know we’re supposed to be having dinner with the Lewis-Smiths on Thursday? Looks like I’m going to have to work late that night – there’s some important stuff I have to get done. Would you mind going on your own?”

You had time aplenty to watch the Arsenal match and the Singapore Grand Prix, but now your work has to be done and the cost is your home life.

Pension Fund Risk Management

Nowhere is theta / time decay more in evidence than when it comes to the task of repairing the pension fund. This is where the price of procrastination comes into its own in dramatic fashion.

“Let's not hedge the real yield right now. Yes, it is far and away the biggest risk facing the pension fund, and yes we've known that for years, but there's bound to be a better time to deal with it.”
 
“Let's stick with this adviser a wee bit longer.”
 
“Let's have a committee meeting to discuss our options.”
 
“Let’s ask Bob to look into that and report back.”
 
“Add it to the list...”
 
The problem is, the sands of time are sinking and theta is rising.
 
One pension fund I met recently, is due to pay out an increasingly large stream of members' benefit cash flows that are scheduled to peak around 2035, from which point they will slowly diminish steadily, until the final benefits are paid out to the last surviving pension fund members circa 2090.
 
Something like this:
 

Except, in the real world that won't actually happen. The pension fund is badly underfunded and, for the last five years, the fund’s trustees and advisers have prevaricated and procrastinated, and dillied and dallied, in a frozen fog of paralysis by analysis.
 
To quote Euripides (-ish): “The mills of time grind exceeding slow but they grind exceeding sure.” Thus, on any prudent view, the pension fund now has insufficient assets to make pension benefit payments past about 2028. The guys who run the pension fund haven't worked that out yet, are oblivious to theta and are living on the never-never; that time-honoured illusory promise of better times ahead which, in practice, no matter how much better they are, cannot rescue the pension fund and its members. It's all gone too far; theta has done its grim work and now there simply isn’t enough time. The pension fund needs to earn over 8% on its assets every year until 2090.

In the immortal words of Bradley Cooper (The Hangover (2009)): 

“That’s not gonna happen.”

Ironically, the  pension fund's younger members (now in their late 30s) are still dutifully paying their hard-earned contributions into the pension fund, unaware that by the time they come to draw their benefits in 30 years time, the assets will almost certainly have dwindled to nothing. They are unwittingly funding the full benefits of current pensioners but will themselves, in all likelihood, be left compromised. Come to think of it, there's an Italian word for when your money gets paid out of a scheme to other people – “ponzi”.

 

Charles Ponzi - 1910 (police mugshot)

All this is wretched stuff for sure, but, extraordinary as this may be, the awful truth probably will not dawn on the trustees until the coffers actually begin to run dry in about 15 years time, approximately 60 years too early.
 
In the meantime, they will desperately continue to hike contribution rates, praying for rain that never comes...
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I started decorating the bathroom in 2000 when I moved in to this house. The tins of paint are still on display 12 years later and the work awaits completion. I still haven't decided what colour towels I'm having.
 
Caroline, Wirral (BBC Readers’ tales of epic time wasting)
 
 -------------------------------------------------------------------------------------------
 

BTW, if the entire country puts off thinking about saving for retirement, is that procrasti-nation?
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]
 

In the financial crisis of 2008, a number of credit classes were tarnished by investors rushing for the exit and suffering heavy losses. Asset-Backed Securities (ABS), Sub-Financial debt, Collateralised Loan Obligations (CLOs) and junk bonds are some of those still suffering from a branding issue. With the upturn in markets since 2009, and greater understanding of the liquidity and credit risk inherent in these assets, many of these today offer compelling opportunities for investing. The lack of education presents a major hurdle to investment.

2. Implementation
 

It is important for pension schemes to consider asset allocations on both a risk and return basis, which requires the expertise of an asset manager with a risk-adjusted return focus, rather than one whose aim is purely to outperform a benchmark. “Total return” rather than “absolute return” should be the focus. Challenges also exist with regards to managing any required currency hedging.

3. Scarcity
 

As shown above, not all credit classes are available across all markets. The partial-yet-significant re-allocation from equity to credit by pension schemes globally over the last decade means there are more investors looking to access the same opportunities. In addition, the returns available vary from region to region, with the widest credit spreads typically available in Europe (unsurprisingly given the current climate).

Key Takeaway

The current opportunity to access attractive spreads across a diversified range of credit-based investments is driven by a lack of lending appetite and by the bank deleveraging. So far in this credit cycle, in the post-subprime world, defaults have been low and investors handsomely rewarded. Defaults will of course occur, but we believe that at current levels a diversified buyer maintains an adequate margin of safety, even under severely stressed scenarios.
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

 

The underlying idea is to keep the overall amount of risk (as measured by volatility) coming from the total equity plus cash portfolio roughly constant. This is in contrast to the conventional approach of making a fixed allocation in monetary terms to equities, the risk of which will vary substantially through time.

Despite the simplicity of the concept, a study of returns since 1998 shows that, across equity markets and time periods, the strategy has delivered equity-like returns with substantially lower volatility. The results are robust to changes in the rebalancing frequency and precise calculation of volatility measure.
 

In September 2009 S&P launched a set of indices available on Bloomberg which follows the performance of various volatility controlled portfolios; a number of indices are available, and some of them are illustrated below:
 

Source: Bloomberg, Redington

(1) replacing T with E at the end of the ticker name gives the excess returns series relative to the underlying equity market, as opposed to the total return index

 

(2) Volatility measured as the annualised standard deviation of daily log returns
 

In the July/August issue of Insurance Risk, a particular article entitled “The Volatility Challenge” highlighted the potential Solvency II capital savings that could be realised as a result of  investing in equities via this volatility control framework as opposed to via “straight” equity. The potential savings were substantial. The article cites examples of Fund Managers running mandates for insurers targeting a capital charge of 15-20%, compared to the Standard Formula capital charge of c40% for developed market equity.

 
Volatility Control is not CPPI

Although the two may seem similar, the Volatility Control approach is different to the ill-fated Constant Proportion Portfolio Insurance (“CPPI”), which has been popular at various points in the past but has come out with a less than favourable reputation. The main difference between the two is that CPPI looks to replicate the delta of an option, which can involve a much sharper deleveraging out of equity in the case of a market fall. The Volatility Control approach, by contrast rebalances as the trailing measure of equity volatility increases.

Although Volatility Control is a new concept for many pension fund trustees, it is an established approach that has been applied with success within hedge funds and other asset managers for some time. Indeed, there is a broad category of “Diversified Beta” funds that broadly use a Volatility Control methodology to control their allocation to a broad set of market risk factors such that a constant amount of risk comes from each factor.

As we look to the past, we see many of the major shifts in pension funds’ activities stemming from successful approaches used within the traditional banking or asset management space; it may be that Volatility Control offers pension funds a new approach to managing assets that helps to be aware of and react to changes in risk, volatility and reward.
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

 

If I gave the same fixed cashflow to four different fund managers I would expect them to agree on the PV01 of that swap to within less than 1%. The calculation is standard and, on the whole, unchangeable. However, if I were to give the same LPI cashflow to four fund managers, it is quite possible they would not agree on the IE01 to within 20% of each other.

The calculation of IE01 lacks a prescribed standard; values of the IE01 of your pension scheme could be materially different to those identified by another advisor or fund manager, and this could have an impact on the portfolio that would most closely hedge the liabilities. While the perfect formula for an IE01 calculation is still an elusive concept, pension funds should be asking their advisors who calculates this value for them, and asking for more clarity in order to initiate a debate on the correct approach.

Something so influential in the hedging of liabilities needs to be better understood, and pressure needs to build to find a more accurate and standardised measurement.
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

 

 

In terms of liquidity, the point is that one has to look from an overall holistic perspective so it would be quite reasonable to have liquid assets sat alongside illiquid assets, in the way one has “risky” or “growth” assets sat alongside “matching” assets.
 

Liquidity needs to be very well understood, in particular with respect to collateral management if the scheme has derivative positions. It’s not a simple question to answer but the over-riding factor is that as part of a scheme’s good governance it needs to ensure that, howsoever it is invested, it maintains the requisite level, and a very prudent level at that, of liquidity in order to meet day-to-day demands as need be, and also to withstand in some instances a severe crisis – the so-called tail-end events.
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]

 

Despite significant economic headwinds and uncertainty over-hanging financial markets, we have seen a "relief" rally following the recent announcements from the ECB, Wednesday's decision from the German Constitutional Court, and the FED's announcement last night confirming an open ended round of QE until unemployment drops "substantially".
 
For most pension funds, this rise in long term gilt yields and general support for risk assets will lead to an improved funding ratio.  Whilst we recognise that these yield levels still represent near record lows, we believe that, under the right scheme-specific risk framework, this may create opportunity for clients to "lock-in" this improvement and take a further step along their funding "flight plan".
 
Another upcoming policy event that may have an impact on the index linked gilt market and inflation swaps pricing will be Tuesday's publication of yesterday's CPAC (CPI Advisory Committee) meeting minutes.
 
We would be happy to discuss this current opportunity with you further and/or how we might be able to help you take advantage of similar opportunities in the future, always under a disciplined, funding objective consistent manner.
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]
 

 

 

The upshot is that the policy of strict conditionality for ECB-ESM support, now backed by the force of law in the German court judgement and the force of democracy in the Dutch election, has created a potential doomsday machine. No country will get any support from the ECB unless and until its economy deteriorates to the point where it is prepared to accept very onerous bailout conditions. And once these austerity conditions are imposed, the economy in question will surely sink deeper into recession, while political conditions become even more unstable. Does this sound like a credible solution to the euro crisis?
 

Should any reader of RedBlog be interested in receiving GaveKal Research on a free trial please contact robert.murphy@gavekal.com
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

 

The art of hedge fund investing is to realise that it is not a static game; and investment and allocation fitness is as important to buying hedge funds as stamina and endurance are in the Olympic sports.

New hedge funds start up every year and the elite FoHFs, like trained coaches, are great at spotting and nurturing talent. For example, Permal, like Tom Daley, continues to dive into the opportunities pool with the launch of its fourth fund. 

 

Our five-year review of the global FoHF industry proves that this trend is true of the allocators, too: of the 147 firms that were in the rankings in June 2007, only 78 are still there. It is not the same club, but with 103 members it is clear that new fresh blood is coming in year after year, with InvestHedge Award contenders The Bornhoft Group, Persistent Asset Management and Thalia being perfect examples of this.
 

The majority of those that are still in the ranking for five or more years – like Michael Phelps, the most decorated Olympian of all time with 22 medals to his name – have won many performance gongs.
 

I wonder if de Coubertin would mind too much if the global FoHF industry adapted his famous quote: “Hedge fund investing is not a system but a state of mind.”
 

Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer
 

The Importance of Saving

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

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Source: Frontier Capital Management

Source: Frontier Capital Management

Source: Lawrence Clarke Investment Management

Source: BarclayHedge

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

Should any reader of RedBlog be interested in receiving GaveKal Research on a free trial please contact robert.murphy@gavekal.com

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

In true American entrepreneurial spirit, Porter went on to write the book ‘The Competitive Advantage of Nations’. I reckon it was less successful as I never heard about it in any of my economics classes and was able to pick up a copy for DM 10 on sale, not bad for 800 pages!  It is a shame as many European politicians (actually make that all) would have greatly benefitted from reading the book.

Whilst Porter looked at various factors which make nations competitive, ultimately a competitive nation is a country where companies/industries are successful as they have a differentiation or cost advantage.  In plain English a country creates either unique, often pricier products or products at a cheaper price, which often will translate into competing either via know how/innovation or cheap labour cost.

Redefinition of cost advantage over the last 20 years

In Europe, the Southern nations were characterised by cheaper labour costs for many years and hosted such industries as the textile industry. However, the concept of cheap labour has utterly changed over the last 20 years. Whilst the world has not physically expanded, economically it has with Eastern Europe and China/SE Asia joining the economic framework. No guessing where textiles are produced these days! Naturally, the ‘new’ nations started to compete initially via their low labour costs as a result pushing many European nations into a ‘stuck in the middle’ position. Some of these developments were camouflaged by either expanding debt fuelled industries (real estate bubble) or by states compensating for this development by transfer payments and growing debt.  What does that mean for the solution of the Euro crisis?

Nations need ‘product’

As much as companies need ‘product’ which people want to buy, nations need ‘product’. Nations without a competitive advantage will not be able to prosper.  

To build competitive industries is not a short-term effort. However, it is the only route to growth as regaining a cost advantage over Asia or Eastern Europe is unlikely, regardless the outcome of the Euro-zone crisis. Even if some nations might return to their own currency, competing purely on labour cost will be impossible.

This will be clearly harder to achieve for European nations which currently do not have a sufficiently strong position in more value-added industries. Especially as it sometimes feels like the concept of competitive advantage can almost be re-written into: producing products China wants, but can’t produce (BMW, Louis Vuitton) or products which China can produce anyway cheaper and there is no need to bother. The situation is not quite as bad, but it will require structural reforms and investments in education which should make many European nations again more attractive to invest.

Nations like the city state of Singapore have actively (and successfully) pursued  strategies to position themselves in the globalized world, away from competing with cheap labour cost. If a country like Finland which is half of the year in semi- darkness can mange, why should such countries with beauty and sunshine like the Southern European nations not be able to cope?  If nations need advice, Tyler Brule (as of the FT’s Fast Lane) at Monocle magazine has been championing this theme and would probably be happy to advise.

Germany’s economic strength not a given

Germany currently enjoys a stronger economic position than many of its European partners as much of its industry is based on unique, usually technology-based products which enjoy global demand. However, it is not a given that the country will be able to maintain its competitive advantage over the next decade.  Countries like China are gradually moving up the value chain and are building up their technology knowledge, resulting in increased competition in more advanced industries. Hence designing a solution to the Eurozone crisis which will rely on permanent transfer payments from stronger nations to weaker ones is a risky strategy as the economic strength of Germany might be harder to maintain in the future.

Reducing Germany’s competitive advantage is ill-advised

A popular demand, championed among others by FT’s Martin Wolf, is that balance of payments surplus nations (Germany) need to spend more to allow the deficit nations (PIIGS) to balance their books. This requests Germany to increase its consumption and also to allow for higher wages to narrow the competition gap towards other less competitive European nations. The problem with this idea is that goods produced in Europe are not inter-changeable. German machinery producers are more likely to compete with US or Asian companies, than with Greek or Portuguese ones.

Just because German labour cost would become more expensive, buyers won’t shift to Greek cars (there are none), probably neither to French cars as they might rather buy an Asian car. Equally German workers are unlikely to spend their extra earned money on olives (how many olives can one realistically eat?).  So, suggesting Germany should become more uncompetitive will probably only help turning Europe into a complete disaster zone of over-aged and over-indebted nations. Instead, the nations need to take their cue from the first point: nations need product. If you have only a limited amount of products that other nations want to buy, asking stronger nations to become also uncompetitive seems to be an odd way of fixing the problem.
 

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On June 1, 2009, Air France Flight 447 crashed into the mid-Atlantic during what should have been a routine night flight from Rio de Janeiro to Paris. All 228 passengers and crew perished. The cause of the crash was, on the face of it, a complete mystery. The Airbus A330-200 was a highly sophisticated aircraft and was being flown by three well-qualified pilots. The captain alone had 11,000 hours of flying experience.
 
In theory, such a crash should have been nigh-on impossible. But it happened. The results of the crash inquiry have finally been published. It turns out the junior pilot made a major error which he persisted with. The other two, more senior, pilots failed to appreciate what he was doing until it was too late to rectify. They simply ran out of time.
 
If you are involved in running a pension plan, there are some highly relevant lessons from the tragedy of Flight 447.
 
Here’s what happened on that fateful night:
 
"I'm in TOGA"
 
High over the Atlantic, between Brazil and West Africa, the plane’s pitot tubes froze. These are the small, forward facing, ducts that measure airspeed. In itself, that should have been no big deal; however, it caused the plane’s autopilot to disengage - the plane was now in the hands of Pierre-Cedric Bonin, the most junior of the three Air France pilots. At the same time, the plane hit turbulence and Bonin made his mistake. For reasons which are not clear, he reacted by pulling the nose of the plane up. The aircraft began to slow dangerously, and multiple alarms sounded loudly in the cockpit: Stall! Stall! Stall!
 
At this point, Bonin should have lowered the nose, picked up speed, and all would have been fine. But he was disorientated, saying to himself:
 
“I’m in TOGA, huh?”
 
TOGA stands for “Takeoff & Go Around” which is what a pilot does when aborting a landing approach. At 38,000 feet, Bonin was a very long way from being in TOGA. However, he gunned the plane’s engines to full power, keeping the nose tilted upwards, in an “angle of attack” of 15 degrees – exactly as though he was aborting a landing a few metres off the ground.
 
At this altitude, and in super-thin air, it was about the worst thing he could have done. The plane began to climb and then, with the nose pointing up at an incredible 40 degrees, and slowing to just 60 knots, Flight 447 began to stall.
 
Now, although the plane’s nose was sharply up, the plane was simultaneously descending fast. The Airbus’s electronic navigation screens suddenly went blank, struggling to interpret this apparently contradictory data.
 
With David Robert (his co-pilot) and Dubois (his captain) shouting at him to lower the nose, Bonin did so. It was the first time in three minutes that Bonin had done the right thing . But as the plane’s electronics kicked back in, the Stall! alarm sounded again. Bonin, who by this time had no idea what the plane was doing, resumed the climb. It proved fatal. Seconds later the plane reached its propulsion ceiling, stalled and fell out of the equatorial night sky.
 
As the plane plummets, Captain Dubois yells: Climb!, Climb!
 
Bonin then whispers:  “But I’ve had the stick back the whole time...”
 
In a terrible moment of clarity, David Robert and Captain Dubois finally work out what has gone wrong:
 
1. Bonin had made a catastrophic error of judgement. He had been climbing "the whole time" - holding the control stick back in the nose-up position and, eventually, stalling the aircraft.
 
2. Robert did not know what Bonin was doing (the control stick is situated out of the co-pilot’s line of sight on the A330-200).
 
3. Dubois had failed to supervise them - he was out of the cockpit having a break.
 
4. In the final four minutes of the flight, none of three pilots calmly scrutinised the navigation instruments in order to establish what was happening to the aircraft under their command.
 
By the time the crew had figured things out, it was too late.
 
As the report says on page 182 (Para 2.1.3.5):
 
“The crew had almost completely lost control of the situation.”
 
According to the report, two key factors contributed to the crash. First, Bonin assumed, wrongly, that it was impossible for the plane to stall. Second, he believed, also wrongly, that he was doing the right thing by keeping the plane in the nose-up position. It was a disastrous combination of wrong beliefs.
 
The aircraft remained stalled during its entire 3 minute 30 second descent from 38,000 feet before it hit the ocean surface at a vertical speed of 150 km/h (90 mph).
 
Salutary lessons for anyone involved in running a pension plan
 
Trustees are engaged to sit on the pension plan’s flight deck and to take it from the underfunded favelas of Rio, to the plentiful abundance of Paris, where every member gets paid her benefits in full and on time.
 
It should be a routine journey, but, increasingly, it is apparent that some pension plan trustees are struggling to fly the pension A330-200 Airbus. The air is ultra thin, there is plenty of rough turbulence, and blaring klaxons are going off left, right and centre.
 
At times like these, there are key moments when the correct decision has to taken – first time. There are no second chances. If the pension plan’s crew reacts incorrectly to incoming data, there is very little opportunity to work out what has gone wrong. As the stress mounts on the trustees, the situation becomes more and more difficult to correct.
 
For instance...

I recently came across a small pension plan which, for historic reasons, has no corporate sponsor.  Along with every other defined benefit pension plan, the trustees have had ample opportunity to hedge (insure) against a falling real yield (and rapidly rising liabilities) but, up on the flight deck, someone decided not to pursue that route. A Bonin (by another name) chose to keep doing the same thing (relying on the equity risk premium and failing to hedge) until the plane stalled.
 
Here’s an extract from their latest Funding Statement:
 
“In accordance with statutory requirements, the Trustee has now received an actuarial report which provides an approximate update of the funding position of the Scheme as at 1 January 2012. Unfortunately, this shows that the funding level of the Scheme deteriorated markedly during 2011 from 63% to 48%, with the shortfall increasing from £3.6 million to around £6.3 million.”
 
It is not a big scheme, but to the good folk who are reliant upon it, it’s all they have.
 
The accompanying explanation from the pension plan’s flight crew is woefully inadequate:

“This problem is not specific to the Scheme, as these conditions have had a very serious effect on almost all defined benefit schemes in the UK. Current financial market conditions are very unusual by historical standards and a return to more ‘normal’ conditions is expected to be beneficial for scheme funding, but we do not know if or when that may happen.”
 
Those last few words are the equivalent of Pierre-Cedric Bonin’s and David Robert’s abject admission to Captain Dubois in the final moments of Flight 447:
 
“We have lost control of the plane.”
 
No doubt, Bonin-like, the trustees believed it was simply impossible for the real yield to fall to zero percent. And, for sure, during the last five years, the trustees also believed they were doing "the right thing".
 
On both counts they were wrong and the pension plane has stalled. It should not have happened. But, with a funding level of 48%, it undoubtedly has.
 
It is a sobering thought, but there are many other pension plans which, but for massive contributions from their corporate sponsors, would be in the same position.
 
And whilst there are plenty of sophisticated navigation tools available to make sense of these difficult flying conditions and frozen pitot tubes, many pension plans simply do not use them.
 
Flying the Plane
 
If you are a trustee sitting up on the flight-deck with your hand on the control stick, here is a set of questions designed to help you figure out whether you are cut out to fly the plane to Paris. If you are, that’s great. If you are not, you may want to think about getting yourself up to speed.
 
I hope you find it useful:
 
https://www.surveymonkey.com/s/Are_you_a_BlackBelt_Pension_Plan_Trustee
 

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Government annual surplus or deficit

Source - BBC News

 

Government debt as proportion of GDP

Source - BBC News

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Age-otori (verb): “to look worse following a haircut”.

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      Then...                                                                                                     ...Now

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The double-dip recession so dreaded last summer has happened, but not where investors had expected and certainly not with the predicted market results. The announcement of a -0.2% fall in UK GDP (against the expectation of an 0.1% increase) confirmed that Britain is now the largest economy officially in recession, having suffered GDP declines in two consecutive quarters, averaging an annualised rate of -1.0%. Yet sterling did not budge from its strongest trade-weighted level since August 2009 and its best level against the dollar since the US double-dip scare last summer. The stock market seemed equally relaxed about the British recession, with almost no change in the FTSE index. And, most surprisingly, sterling bond prices actually fell half a point in response to the unexpected GDP decline.
 
Of course, it can be dangerous to draw any sweeping conclusions from a single day’s trading, but just imagine how the markets would behave if the Q1 GDP figure recently announced by the US showed an -0.8% annualised decline. (For the record, it came out at +2.2% - consensus forecasts on Wall Street were for a 2.5% gain, while we expected something close to a 3% improvement.) If the US economy had experienced anything like the slump in economic activity that is now a statistical fact in Britain, the dollar would be tanking, Wall Street would be collapsing and US bond yields would be falling below Japan’s. So why are the markets so relaxed about Britain? Are markets seeing reality more clearly than the statisticians? Or is this a case where investors are in denial and over-optimistic about Britain, as they have been ever since David Cameron became prime minister in 2010? If so, then this complacency creates an opportunity, just as it did a year ago, to sell sterling and speculate on another round of quantitative easing.
 
A popular view in London is that this recession will prove a statistical illusion. Optimists point out that the 1Q decline in GDP was almost entirely due to a collapse in construction output that was not reflected in private sector construction reports, that surveys of business sentiment were pointing to a moderate rebound in growth and that the latest unemployment and retail sales figures have shown signs of improvement. It is widely expected, therefore, that the GDP decline will be revised away and the British economy will continue to “bump along the bottom” rather than sinking even deeper into recession.
 
But these expectations are probably unrealistic, for five reasons. First, the decline in construction activity was due entirely to a very real cause—a 25% drop in public sector investment—that is not going to be reversed. Second, the latest monthly manufacturing figures have also been weak, belying the optimism in industrial surveys. Third, the +0.1% 1Q estimate of service output was also extremely disappointing, with all of the growth coming from government while private sector services declined. Fourth, the previous quarter’s GDP figure, far from being revised upwards as initially expected, was in the end revised down. Finally and most importantly, the second quarter is likely to be even weaker than the first because the large reductions in welfare benefits and public spending at the heart of the Cameron government’s fiscal austerity programme only came into effect this month. And to make matters worse the special four-day holiday announced for the Queen’s diamond jubilee will probably close down a large part of the British economy in early June, causing an even bigger downward distortion to 2Q statistics than last year’s royal wedding.
 
The upshot is that the British recession, far from being dismissed as a brief statistical illusion, will become more protracted and alarming in the months ahead. With the Cameron government already in trouble as a result of last month’s budget, the Murdoch scandals and splits in the coalition over reform of the House of Lords, the confirmation of a double-dip recession will further destabilise politics. In the very long run, the reforms may well succeed in making the British economy stronger – and will probably get the Conservatives re-elected. But the next 12 months are likely to be a much tougher and more turbulent period than most expect.


Should any reader of RedBlog be interested in receiving GaveKal Research on a free trial please contact robert.murphy@gavekal.com

 

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'Lose Yourself'

The chart above shows the movement of 30 year Gilt yields and FTSE 100 for the last month.  Gilts have seen a range of 28bp from high to low while the FTSE has a range of 6.2%. Fortunately, pension schemes may have more than ‘one shot, or one opportunity’ to de-risk but it requires trustee boards to have the ability to ACT. 

Why is it important to ACT?

The latest PPF 7800 figures showed an improvement in funding levels during March, helped by higher gilt yields and equities.  However, the latest markets movements suggest a deterioration in funding levels for April, if the trend continues. As a rule of thumb, PPF estimate that a 7.5% rise in equities leads to a 4% rise in asset values, while a 30bp rise in gilt yields reduces liabilities by 5%. Unfortunately, we have seen both equities and yields fall this month.

Schemes with an appropriate decision-making process have been able to ‘lock-in’ some of the gains by de-risking as sentiment improved. According to a survey by Schroders, these schemes make up the minority with just 17% of those surveyed able to make immediate investment decisions. In contrast, over 50% of respondents said it takes longer than one month for trustee boards to decide.

Eminem only had one shot. If your scheme has a second shot, would you capture it or just let it slip?

 

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