The ramifications for investors of the UK’s referendum decision will take some time to materialise.
We are entering uncharted territory – nobody knows precisely how Brexit will be implemented or its consequences.
What is clear is the result will herald a period of considerable uncertainty and market volatility.
If we have learnt anything from history, it is that these kinds of major events happen surprisingly regularly. Which is why it is so important to design and implement a robust, risk-managed and well-diversified investment strategy for the long term. And why it so important to set prudent liquidity and collateral buffers.
In this note we set out our high-level thoughts on the implications for risk management, asset allocation and the due diligence of fund managers.
Here are a few key areas which can provide the most value at this time:
- Liquidity, treasury and collateral management
- Transaction costs
- Monitoring of asset manager funds
- DC communications
Defined Benefit Schemes
The comments that follow cover our five asset categorisations: LDI Hub, Liquid Markets Strategies, Liquid and Semi-Liquid Credit, Illiquid Credit and Illiquid Markets Strategies. (See chart below for a reminder of how this works.)
In current volatile markets, we believe pension funds should maintain existing hedging programs and that liability interest rate and inflation risk remain unrewarded risks. Right now, maintaining a close dialogue with LDI managers on collateral requirements – including those relating to currency hedges and synthetic equity positions – is recommended.
Asset allocation should be designed, with your advisers, to include prudent levels of collateral and liquidity. Collateral levels should be reviewed for your fund to determine if there is a need for rebalancing.
Liquid Markets Strategies
Principles of risk management and diversification in liquid markets remain unchanged.
You should continue to monitor individual strategies to assess both the potential return and risk mitigation that they offer.
Liquid and Semi-Liquid Credit
According to the feedback we have received so far from our market contacts, liquidity in Sterling debt has been, as might have been intuitively expected, negatively affected following the referendum result. Transaction costs are therefore likely to remain elevated for some time. If you are considering asset allocation shifts involving this asset class, particular attention should be paid to transition costs; talk to your adviser about whether transaction costs outweigh the strategic benefits.
The long lead times in sourcing and pricing in illiquid assets and the volatility and poor liquidity in tradeable markets makes the calculation of illiquidity premia unusually challenging. This means there is significant risk of “stale pricing” in many illiquid asset classes. Review any uncommitted illiquid-credit-only allocations and consider mandates where managers can allocate across a wide range of liquid and illiquid credit assets.
Illiquid Markets Strategies
You should monitor redemptions from pooled vehicles and how managers deal with any potential illiquidity mismatches. In line with illiquid credit, any uncommitted illiquid-market-only allocations should be reviewed.
Defined Contribution Schemes
Increased market volatility will be of particular concern to DC plan members. For younger members, it is vital that the heightened uncertainty does not diminish engagement or reduce contribution rates.
For members approaching retirement, it is important to avoid knee-jerk reactions. In order to help members navigate these challenges, providing additional communications, tailoring the messages to the different generations within your membership can be effective.
Investment Managers – Ongoing Operational Due Diligence
The vote to leave will result in the UK’s relationship with the European Union being renegotiated; at this stage the precise timeline and details of how this could affect your investments are unknown. Understandably, pension funds may be concerned about the implications of this process for their asset managers.
Your adviser should actively engage with all of your asset managers to assess the potential ramifications. This should include (but not be limited to) reviewing their contingency plans around the potential regulatory impact and the overall stability of the manager’s franchise.