NEWS

The new AA: funds hedging for “tail whippings”

BRITTAIN_Bruce_june2010The shock of asset class correlations going to one during the global crisis has prompted new ways to look at asset allocation among institutional investors and managers, which have started to drill down into the risk factors driving markets.

Investors should look beyond asset class diversification and analyse the risk factors driving returns and, crucially, how these factors behave during market crises as they structure portfolio defences, according to PIMCO’s Bruce Brittain (pictured).

There are three risk factors that “matter” in asset allocation, Brittain, a member of PIMCO’s product management group, said. They were equity, the level of interest rates and the slope of yield curves. Credit risk, he said, was a derivative of equity risk.

“We try to encourage investors not to think in asset class directions but in risk factors. But it’s instructive to go through asset classes and undo the risk buckets that drive returns,” Brittain said.

These factors drive the performance of “traditional” equity and bond portfolios, and also “endowment-style” funds investing in multiple asset classes, including large allocations to illiquid assets.

Brittain, speaking at the Fiduciary Investors’ Symposium in Sydney, on June 1, compared the risk exposures of a portfolio with a 60 per cent allocation to the MSCI World index and 40 per cent to global bonds, with that of an “endowment-style” portfolio holding 15 per cent exposures in each of US equities, global equities, US bonds, private equity and absolute return (totalling 75 per cent); 10 per cent to real estate; and 5 per cent in each of emerging markets equity, venture capital and commodities (totalling 15 per cent).

Despite the sweeping differences in asset allocation, the risk exposures of both portfolios were strikingly similar.

The traditional portfolio was 97 per cent exposed to broad equity risk and 3 per cent to a category termed “other”, while the endowment-style fund was 87 per cent exposed to broad equity risk, 7 per cent to currency, 3 per cent to commodity, 2 per cent to real estate and 1 per cent to the “other” category.

Brittain said the equity risk factor “sneaks” into endowment portfolios through securitised property exposures and private equity, which he described as “public equity with an illiquidity premium”. This contributed to the correlation of between 0.6 and 0.7 of the endowment portfolio with the MSCI World index since 1993.

It is the dominant factor during market crises, he said. Correlations among asset classes rose “in absolute value” when equity markets were extremely volatile, meaning that diversification provided small defence in market crises.

He said market shocks, such as those described by the “fat tails” that lie outside a normal distribution of returns, occur more often than most investors and risk management models predict. Since 1982, when Mexico defaulted on its debt, global markets had experienced nine crises, such as the 1987 Black Monday crash, the Asian financial crisis and the recent global recession.

He said traditional risk management and pricing tools often underestimated the frequency and severity of these “left tail” events. Models largely based on economic and market rationality, linearity and normal bell curves were doomed to fail.

So what should institutions do? Given the dominance of the equity risk factor, he said they should focus less on asset-class diversification and spend money on a hedging program to mitigate whippings by tail events.

Brittain said a hedging program over a traditional portfolio designed to limit losses to 15 per cent in a crisis could be run on about 100 basis points each year. For the next three-to-five years as we recover, or not, from the current crisis longer-dated, out-of-the-money options would be useful for hedging portfolios.

Turning to PIMCO’s market outlook, he said the major emerging markets of China, Brazil, India and Russia provided richer opportunities for debt and equity investment, and that deleveraging across Western economies will continue to impact returns “for some time”.

“But the thought process stops there, because there are serious challenges in understanding the current cyclical context of recovery” or possible recovery “from a massive financial shock,” he added.

“I wonder what it will be like when Ben Bernanke decides he has to raise interest rates by 300 basis points.”