Volatility back big time

NEW YORK — The sharp decline in global markets earlier this month will likely have a significant impact on institutional investors' collective mindsets and long-term approaches to protecting their liabilities.

"Volatility is back," said Michael Peskin, managing director in Morgan Stanley's Global Pension Group, New York. "We have had a couple of years of low volatility, but the riskiness of the market is asserting itself again."

Shortly after the U.S. markets reached their highest levels in six years earlier this month, major sell-offs prompted a roughly two-week decline in both domestic and global markets.

But U.S. institutional investors appear to remain unfazed by the downturn.

"They're not panicking," said Ken Froot, a Harvard University professor of business administration, and co-creator of State Street Global Markets' Institutional Investor Confidence Index. "The periphera is not nearly as scared as the center (meaning short-term investors)."

The Standard & Poor's 500 stock index, for instance, declined 5.6% over an 11-day span beginning May 8. In that same period, the Morgan Stanley Capital International Emerging Markets index declined roughly 14% after hitting its all-time high and the broader MSCI EAFE Index dropped 8.2% between May 8 and May 22.

Commodities fluctuated wildly as well. Gold, which reached a 26-year high of $732 an ounce on May 12, declining roughly 7.6% the following week, its largest weekly decline in 16 years.

"It's really just a return to more normal levels of volatility," said David Hammerstein, chief strategist at investment consulting firm Yanni Partners Inc., Pittsburgh. "The downturn shouldn't be a catalyst to completely change your investment policy, but it could confirm investors' needs to be diverse and to stabilize their liabilities."

Ultimately, the downturn could serve as a wake-up call for pension plans to begin shifting to more of an asset-to-liability-based approach to investing, said Mr. Peskin.

"There has been a great deal of talk about such approaches, but by and large there's been a lot less actual movement," said Mr. Peskin. "It's moving at a measured pace, but this could be an event that leads pension plans toward adopting a more risk-management-based approach."

Robert Collie, director of institutional research and strategy at Russell Investment Group, Tacoma, Wash., echoed Mr. Peskin's support for liability-based investment approaches, and said the move has been in the works for several years.

Along with the recent market volatility, changes in pension accounting loom, while many companies have improved their overall funding levels in recent years. Potentially, new accounting regulations could force corporations to mark their pension investments to the markets, which would increase the volatility and influence on a company's financials.

"Even though there has been a brief decline, the markets were run up for a long period of time and it (the decline) may have actually brought us back to where we should be," said Mr. Collie. "So if there was anyone out there starting to relax, this was a wake-up call."

After several years of being dramatically underfunded, pension plans belonging to S&P 500 companies were underfunded by less than $50 billion combined at the end of 2005, compared with $98 billion at the end of 2004, according to preliminary data released last week from Goldman Sachs Group Inc., New York.

Gabriella Barschdorff, vice president and strategic investment adviser at JPMorgan Asset Management, New York, acknowledged it is virtually impossible to predict the direction of the markets and interest rates. Still, she said, pension plans should adopt a long-term approach to matching their liabilities, and focus on maintaining diverse portfolios.

Even though areas such as emerging markets have performed extremely well in recent years, pension plans must stay focused on reducing their investment risk by consistently rebalancing, said Dick Anderson, senior investment consultant with Hammond Associates Inc., St. Louis.

"Before the drop, we've generally been talking to clients about reducing their risks and moving away from investments that have performed well for a long stretch of time, such as domestic small caps," said Mr. Anderson. "No one was taken by surprise when the markets declined, and we've been telling clients to rebalance and consider adding more alternative investments."

Mr. Anderson added, however, that in certain cases, now might be a good time to be opportunistic. "If there was an asset class that you liked two weeks ago, now you probably like it even more."

Arthur Micheletti, chief economist and investment strategist at money manager Bailard Inc., Foster City, Calif., said most emerging markets still represent good buying opportunities. He said now is a good time to "step up and buy" in emerging markets, aside from Turkey and India, which have "gone vertical" and become vulnerable in recent months.

Mr. Micheletti said the two-week swing earlier this month was a correction in an up market, and the recent declines are only a portion of the sizable gains many investors have pulled in over the last year.