Pension plan sponsors and other investors with long time horizons often rely on high allocations to equities to help them achieve their long-term return objectives. However, they may find it difficult to reconcile the volatility of equity markets with the desire to improve their liability matching. One option to address this problem is to consider a long-duration portable alpha strategy, which combines derivatives-based equity market exposure with a long-duration fixed income portfolio.

The volatility challenge
The possibility of higher expected potential returns—along with liquidity, transparent pricing and broad institutional acceptance—has prompted investors to devote significant allocations to equities. Yet given the volatility of equity markets, some pension plans are questioning traditional asset allocation strategies. For example, the precipitous decline in funding ratios following the multi-year equity market decline at the beginning of this decade dramatically increased interest in liability driven investing (LDI) approaches, which are designed to reduce asset/liability mismatches. Many plans recently faced a similar decline in funding ratios following the broad decline in equity markets during the financial crisis.

While investors expect equity market outperformance over the long term, the impact of volatility in the interim may be significant. Figure 1 illustrates how the duration of the equity market has fluctuated widely over time, depicting the “empirical duration” of the TSX: changes in the value of an investment in the TSX as a function of changes in the value of a 10-year Canadian government bond over rolling one-year periods (monthly from February 1982 to December 2009). While the empirical duration of the TSX during this period averaged -2 years, it swung widely, ranging from -25 to +21 years. That degree of volatility may be more than many plan sponsors are willing to tolerate, despite the increased returns that equities may offer.

Timing risk
Plan sponsors have two competing objectives: to meet return targets and to help reduce risks relative to liabilities. Most plans still have overall asset allocations that heavily favour equities as they attempt to take advantage of higher risk premiums and, potentially, higher long-term returns. The issue is that their efforts to help maximize long-term results can work against their other objective of minimizing risks relative to liabilities.

Many Canadian plan sponsors believe that LDI is an appropriate long-term structure and are interested in adopting LDI strategies. However, they may be reluctant to implement such strategies in the current economic environment. In particular, they are concerned about reducing their allocations to equities when equity values are low and increasing fixed income allocations in a potentially rising interest rate environment.

A portable alpha approach seeks to avoid many of these implementation issues. Portable alpha often refers to strategies in which the desired asset class exposure (beta) is obtained synthetically in the derivatives market, allowing additional return (alpha) to be sourced from a different asset class or active management strategy. The plan is designed to maintain its beta exposure to equities while extending the duration of the portfolio through active fixed income management.

To address plan sponsors’ competing objectives of increasing potential returns and mitigating risk, there are strategies that are designed to provide equity market returns plus a source of excess return potential that is highly correlated with long-term liabilities. Such a strategy uses equity index derivatives—typically, low-cost futures and swaps—to help achieve non-leveraged passive stock market exposure while investing the remaining cash in an actively managed LDI portfolio designed to mimic the pension plan’s liabilities and to help generate additional returns. This type of strategy may offer investors the potentially higher returns of the equity risk premium and also lower risks relative to liabilities.

The use of equity index derivatives enables the investor to maintain full exposure to the equity market without paying for that exposure upfront. As is the case with most “buy now, pay later” arrangements, there is a financing cost—typically around LIBOR—for maintaining the equity index exposure. To the extent that the fixed income portfolio return exceeds that of LIBOR, the strategy outperforms the equity index. Conversely, if the fixed income portfolio return is less than LIBOR, then the strategy underperforms its index. This type of strategy could be tailored to various equity indexes: domestic, international and global. Bear in mind that in this kind of strategy, as in most, fees will affect the total return on the investments.

Performance and portable alpha
While the potential equity market return obtained via derivatives will likely be a dominant driver of performance, the fixed income component of the long-duration portable alpha strategy may offer other benefits relative to a traditional passive or actively managed equity strategy. For example, the inherent long-duration bond exposure may provide a higher correlation with liabilities than traditional equity mandates. Furthermore, since equities can be a significant source of tracking error relative to plan liabilities, this strategy helps to reduce tracking error by introducing long-duration exposure within the equity allocation. In addition, the sources of duration are likely to be better aligned with liability discounting methodologies.

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