Hedging strategies are making their way into European defined contribution portfolios as plan executives look to protect returns in an increasingly volatile market environment.
Sources said the need to protect equity investments is all the more acute as expected interest rate increases in Europe are set to take a toll on portfolios.
Retirement plan executives started preparations due to concerns that aggregate eurozone equity and fixed-income returns are projected to drop to near zero over the next five years from around 5% now, according to Amundi.
Yet asset owners are continuing to allocate to equities as a better option than bonds.
In recognition of the potential for increasing volatility, asset owners are choosing multiasset strategies that use derivatives such as put and call options to protect their positions if markets fall, sources said. Asset owners in Germany, Italy, France and Belgium are all looking to deploy such risk-limiting strategies that can help to sell equity positions when markets go down.
Karin Franceries, head of institutional advisory at Amundi in Paris, said asset owners in Europe are reducing fixed-income allocations to an average of 60% from 75%, and moving the assets to equities. "But that's a huge jump," she said, "so they are looking to buy the protection on the downside for that 10% to 15% of equities."
While defined benefit plans and hybrid plans have used derivatives for portfolio protection for years, it is only recently that such strategies have begun showing up in defined contribution plan default portfolios.
In some countries, including Belgium and France, defined contribution plans are turning to derivatives-based strategies known as dynamic hedging programs. These strategies insulate portfolios against a loss by short-selling stock index futures, since derivatives such as put or call options can mean sacrificing some of the upside.
The €500 million ($582 million) KBC Pensioenfonds, Brussels, recently introduced a dynamic hedging program into the default fund of its defined contribution plan. The program is applied to the 80% of default fund assets in bonds and equities. It increases or decreases equity vs. fixed-income exposure over the course of each quarter depending on the markets.
"The program could move from 60% investment in equity, if the equity market increases, to as low as 20% if the market goes down, by trading index futures," said Luc Vanbriel, chief investment officer of the plan.
"We think of it as a multiasset portfolio, as we no longer consider individual asset classes. It allows us to decrease the total volatility of the (default option's) portfolio. And it is a better way than to look at the volatility of individual asset classes because of correlations."