Investors employ defensive moves to curb market mayhem

Defensive strategies implemented ahead of the coronavirus-induced global market meltdown protected institutional portfolios to some extent in the first quarter.

In addition to plain old-fashioned diversification, sources said strategies that worked to mitigate some of the damage wreaked over the past three months included investment in U.S. Treasury bonds to manage interest-rate risk; hedge fund, global macro, systematic managed futures/commodity trading advisers and insurance-linked securities strategies; and options strategies.

Investment consultants said the most common and effective tactic for a wide swath of institutional investors was interest-rate hedging, especially for corporate defined benefit plans.

"The No. 1 thing that worked well for our advisory and OCIO clients in the last quarter was significant exposure to U.S. Treasury bonds as well as Treasury Separate Trading of Registered Interest and Principal of Securities," said Russell K. Ivinjack, Chicago-based senior partner and head of fund management at Aon Investments USA Inc.

"Not only did Treasury investments work well as an interest-rate hedge, performance was particularly good. No one expected to earn good returns from Treasuries and STRIPS," Mr. Ivinjack said, noting that some pension funds ended up selling their Treasury holdings to rebalance their portfolio allocations as the value of equities, credit and other asset classes fell in the first quarter.

The Bloomberg Barclays U.S. Long Treasury (Total Return) index returned 20.9% and the Bloomberg Barclays U.S. Strips 20+ Year Total Return index returned 30% in the quarter ended March 31.

U.S. Treasuries are a common component of customized multiasset crisis-risk-mitigation portfolios in addition to trend-following and global macro strategies.

The Rhode Island State Investment Commission, which manages the $8.5 billion Employees' Retirement System of Rhode Island, Providence, added a "crisis protection class" portfolio in 2016 "specifically to address inflation, volatility and a market crisis," Evan England, a spokesman for the investment commission, said in an email.

The portfolio totaled $933 million as of Feb. 29 and is invested in long-duration U.S. Treasuries and systematic trend-following strategies. It is part of the system's broader $3 billion stability portfolio, which represented 35.7% of plan assets, a performance summary from the investment commission's March 20 meeting showed.

The other components of the stability portfolio are a $698 million inflation-protection sleeve invested in real estate, private infrastructure and inflation-linked bonds, and a $1.4 billion volatility sleeve with investments in hedge funds, traditional fixed income and cash.

The net return of the pension fund was down 3.1% in the month of February compared to -3.3% for the fund's benchmark, said investment commission staff in a report from the March 20 meeting. For the fiscal year-to-date through Feb. 29, the fund was up 2.6% vs. the 1.1% return for the benchmark. The fund's fiscal year end is June 30.

For February, staff said the stability portfolio was "the primary contributor to the plan's relative outperformance, returning 1.9% as a risk-off environment led to yield declines in fixed-income markets and the crisis protection class helped offset losses elsewhere," according to the meeting report.

The stability bucket's 6.4% fiscal year-to-date net return — which topped its benchmark by 3.6 percentage points — also was a significant contributor to the pension fund's nine-month return, the report said.

March 31 returns are not available yet.

The $243.2 billion California State Teachers' Retirement System, West Sacramento, uses some of the same components in its $22.5 billion risk-mitigation strategy, which represented 9.4% of total fund assets as of Dec. 31.

Global macro strategies in the risk-mitigation portfolio totaled $3 billion: $8.7 billion in long U.S. Treasury bonds; $10.1 billion in systematic managed futures; and $690 million in systematic alternative risk premium strategies.

CalSTRS "established our risk-mitigating strategies asset class after the great financial crisis," said spokeswoman Vanessa Garcia in an email.

"With the recent market volatility, (the) RMS has fulfilled its role. We were able to book some profits from the asset class as the market declined," Ms. Garcia said. "We won't discuss trades, but (the portfolio is) helping to rebalance the (total) portfolio."

Ms. Garcia declined to provide returns for CalSTRS' risk-mitigation portfolio.

The $2.6 billion crisis-risk-offset portfolio of the $17.4 billion Hawaii Employees' Retirement System also produced positive returns during the first quarter, said Howard M. Hodel, investment officer–risk management, in an email.

The portfolio invests in trend-following managed futures, alternative risk premium and long-duration U.S. Treasuries.

"CRO has done as expected during the current downturn in global capital markets and provided a meaningful offset to the growth-oriented strategies in our portfolio. All three components … have (produced) significant positive performance in the quarter, particularly Treasury-duration capture and systematic trend following," Mr. Hodel added.

Mr. Hodel declined to provide returns for the crisis-risk-offset portfolio.

Like a number of other large funds, Hawaii ERS has an options-based equity portfolio totaling $2.7 billion within its growth equity portfolio, which also provides downside protection, according to the fund's most recent investment report as of Sept. 30.

Many institutional investors use options overlays as another defensive measure to protect their portfolios, but it can be costly.

"Pure options strategies are expensive to keep on all the time, but they do protect portfolios in downturns," said James S. "Jay" Love, the Atlanta-based U.S. investment leader for Mercer Investments.

The New Mexico State Investment Council, Santa Fe, which oversees $23.9 billion in state endowments, expects to hire a derivative overlay manager this month. The derivative overlay will permit staff to rebalance the endowment fund's portfolio inexpensively without having to buy and sell securities using futures, said CIO Robert "Vince" Smith in a memo to the investment council for a March 25 meeting.

Investing in hedge fund strategies that tend to provide returns uncorrelated to market activity, as the Rhode Island Investment Commission has done as part of its wider stabilization portfolio, is another common defensive tactic, sources said.

"The first thing we think about is risk at the portfolio level and see that defensively oriented hedge funds act as a true diversifier," said Jonathan D. Pliner, New York-based senior director of investments and head of delegated portfolio management for the U.S. at Willis Towers Watson PLC.

"We look for hedge funds with low beta and not much exposure to the market on behalf of our clients. These strategies, including discretionary and systematic macro, managed futures, and market-neutral, long/short equity and credit, tend to do well in this kind of environment because their returns are uncorrelated to the market," Mr. Pliner said.

Hedge fund index returns for the quarter from Hedge Fund Research Inc. showed the broad HFRI Fund Weighted Composite index was down 8.3%, the HFRI Equity Hedge (Total) index declined 13% and the HFRI Equity Market Neutral index was down 3.1%. But the HFRI Macro (Total) index was up 1.2% and the HFRI Systematic Diversified index rose 2.1%.

Prior to the market toll from the COVID-19 outbreak, some investors had also added or increased exposure in hedge funds that invest in insurance-linked securities.

"We like ILS hedge funds and a reasonable number of our clients are invested in them because they are truly uncorrelated to the market. In a year without natural disasters, so far, these strategies have kept chugging along," said Christopher W. Walvoord, partner and global head of hedge fund research and portfolio management, Aon Hewitt USA Investments, Chicago.

"This is the sort of market (that) hedge funds do well in because they invest in things traditional managers don't and they like exploiting the volatility and complexity premiums inherent in this market," Mr. Walvoord said.