Risky assets don't equal riskier portfolio

Institutional investors are turning to riskier assets to improve performance in the persistent low-yield environment, but they are doing so without dramatically increasing the risk level of their overall portfolios.

Investors have added risk - or rerisked - within asset classes, in a variety of ways including by moving to emerging markets equities from U.S. equities, or by moving to corporate bonds from governments. But these moves have raised risk only marginally because allocations have been relatively small.

These intra-asset-class moves don't “affect the volatility of the overall portfolio much at all,” said Phil Page, London-based client manager at Cardano Risk Management BV. “The big drivers (of pension fund risk) are still the exposure to equity markets and the fact that pension funds don't have much liability hedging as a whole,” Mr. Page said.

Meanwhile, the trend toward reducing risk - or derisking — is much more widespread and has a greater impact on total portfolio risk. Derisking is accomplished by selling equities and buying other growth assets (such as high-yield or emerging markets bonds) or by implementing a liability-driven investment program.

The diversification gained by adding asset classes, along with newer strategies such as low-volatility equity or dynamically managed multiasset strategies that boost risk management, have further dampened overall volatility in investors' portfolios.

“You're seeing rerisking within asset classes ... but all of that is against a backdrop of a wave of risk reduction,” said Timothy F. McCusker, partner and director of traditional research at NEPC LLC, Cambridge, Mass. “There are competing forces there.”

The monetary arrows slung by central banks in developed countries have hit their mark, as near-zero interest rates and quantitative easing have brought real returns on government debt to negative levels. That has made LDI programs, favored by corporate defined benefits plans where liabilities are tied to yields of low-risk bonds, too expensive for many plan executives.

That, in turn, has forced corporate pension plans to carry more risk than they would prefer.

“We would like to hedge more liabilities, but not at any price,” said Chetan Ghosh, chief investment officer at the £5 billion ($8 billion) pension fund at U.K. energy company Centrica PLC, Windsor, England.

However, public pension fund liabilities are calculated using expected rates of investment returns, which act as a target for investment performance. In today's low-rate, low-return environment, meeting or beating the assumed rate of return — typically between 7% and 8% annually — has gotten a lot harder.

“There's a return gap that needs to be made up,” said Steven J. Foresti, managing director at Wilshire Associates, Los Angeles. “The only way to do that ... is to assume greater market risk.”

In response, institutional investors have been adding risk, increasing allocations to assets such as emerging markets securities, high-yield debt and alternatives like private equity.

Combined allocations from U.S. public pension plans to growth assets (U.S. and international equity, real estate and private equity) nudged up to 65.6% of total assets on average in 2011 from 63.6% a decade earlier, according to data from Wilshire.

That increase in growth assets masks underlying moves to diversify, as investors reduced a concentrated bet on U.S. equities and boosted both higher-risk assets (such as international equity and private equity) and lower-risk ones (such as real estate). The net effect: a small bump up to a standard deviation of 11.2% from 11% a decade prior.

“There's without question a shift into risk across many pension plans, but there's a much more efficient use of risk,” Mr. Foresti said.

In a June report, the Center for Research in Enterprise and Technology in Europe, based in Tunbridge Wells, England, said the “emphasis on rerisking is evident in the U.S., especially in the public sector plans with big deficits and mounting political pressure to tackle them.”

The low-rate environment is not just a problem for pension funds. In a July survey of 152 insurance chief investment officers overseeing a combined $3.8 trillion globally, Goldman Sachs Asset Management found that 26% expect to boost overall investment risk. “Increased diversification and better risk management systems should mitigate the impact of higher-risk investment strategies,” the report said.

Increased risk — and diversification — were evident in reported plans to increase allocations to high-yield debt (36% of respondents), U.S. investment-grade corporate bonds (35%), real estate (34%), emerging markets debt (31%) and private equity (27%), according to the Goldman Sachs survey.

The effect on insurers' portfolios caught the notice of U.K. regulators. “We are already aware of changing investment portfolios as some (insurance) companies chase yields and diversify away from traditional fixed-income securities. Where this involves moving into new asset classes, it is crucial that the new risks this strategy presents are fully understood and that investment is made in a suitable control structure,” Julian Adams, director of insurance at the Financial Services Authority, said in an Oct. 22 speech at the Prudential Regulation Authority Insurance Conference in London. The FSA is expected to hand over its regulatory powers to the PRA on April 1.

In addition to giving risk assets a fillip, low rates also have made it more expensive for pension plans to derisk, typically done through a liability-driven investing program. In response, many executives have put implementation of LDI programs on hold.

“In reality, not many pension funds want to be taking more risk in today's environment,” said Alasdair Macdonald, senior investment consultant and head of the U.K. investment strategy team at Towers Watson & Co., Reigate, England. However, he added, “Pension funds have some flexibility about what risks they take and when (and) are saying, "We might need to take the same amount of risk for longer.'”

Centrica's Mr. Ghosh said: “Because of the current low level of index-linked gilt yields, we are exploring substitutes that would broadly give you similar types of hedging but without paying such a high price.” Additionally, many U.K. corporate plans, like Centrica's, are leveraging their index-linked government bonds using derivatives to boost returns.

The moves toward overall derisking and intra-asset-class rerisking have played into the hands of firms like Cardano, which provides outsourced services in the U.K. it calls solvency management, using derivatives to hedge liabilities and to bet across a wide range of assets.

“We are quite skeptical about the prospect of equity returns. Instead, we choose to spread the allocation more broadly,” Mr. Page said. Cardano's strategy is similar to “all-weather” or risk-parity strategies, which spread bets across diverse assets, and employ risk management and leverage to boost efficient use of risks. Firms like Bridgewater Associates LP and AQR Capital Management LLC have long been active in this arena, and dynamic multiasset managers and solutions providers all look to capitalize on this trend.

Catherine M. Keating, CEO of U.S. institutional asset management at J.P. Morgan Asset Management, New York, oversees the firm's strategy and asset management solutions groups, as well as serving the largest of JPMAM's clients. She said the move to diversify investment risk broadly has left clients taking many divergent paths.

“I don't think there is a "typical' institutional investor anymore,” Ms. Keating said. “We've entered a decade of differentiation because the focus for institutional investors is: Who are my constituents and what are my obligations.”