Investors appear to be increasingly averse to volatility. Take the case of private investors – once upon a time they would have stomached the bumps along the road for the potential rewards, but now it seems now consumer sentiment is increasingly short-termist. You need only to look at the retail outflows from emerging markets over the past year recorded by the Investment Management Association.
Chinese equity funds and emerging market fund dropped out of favour, to be replaced with funds with exposure to developed markets that have already significantly rallied. The long term growth story for emerging markets remains intact – but consumers don’t want to wait around to find this out.
A recent article in The Economist concluded that exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. It quotes a paper by Samuli Knüpfer of London Business School who found that following a severe recession in Finland, those hardest hit by the economic downturn were less likely to invest in equities even a decade later. This would certainly fit with the current risk aversion among retail investors.
The National Association of Pension Funds’ chief executive Joanne Segars said last October that volatility was central to how employers and trustees will wish to assure themselves the default fund they have in place is the most appropriate for their membership profile.
Member value was highlighted as a key design trend in the Default Fund Design and Governance in DC Pensions Default Fund report, explained as “trustees and employers looking to combine underlying funds to deliver good returns but with reduced risk and volatility and within what they consider a reasonable cost envelope”.
One of the case studies cited as an objective “keeping the volatility lower and therefore not frightening people with huge swings one way or the other in terms of returns”.
So it is perhaps no surprise that DC defaults are having an increasing eye towards volatility controls.
The Government’s own default defined contribution scheme Nest is so wary of putting off novice pension savers that members in the Foundation Phase of retirement saving are invested in low-risk assets, despite the widely accepted doctrine that the younger you are, the longer the time horizon; therefore the riskier the asset you can stomach.
Although not the only measure of risk, volatility has become almost interchangeable with it. Nest’s Foundation Phase scheme members target returns that match inflation, with a volatility of between 7 and 8 per cent. Members in the Growth stage of the scheme target Consumer Price Index – currently 2 per cent – plus three percentage points, with a volatility of between 10 and 15 per cent.
Nest chief investment officer Mark Fawcett defends the approach saying that after extensive modelling they found there was no impact to the long term growth potential of putting small amounts of cash into low-risk assets at the beginning of a member’s retirement savings plan.
But he did admit that volatility and its management was important to the provider.
“We do care about volatility,” he says. “We don’t want to take more risk than necessary we are aware that people’s appetite for risk is suppressed at the moment.”
Aegon’s new workplace savings scheme launched last April puts volatility management at the core of its investment decisions. The MI Workplace Savings fund targets a “specified level of volatility while offering a safeguard for loss-averse members in the form of active risk management”.
The fund is managed by BlackRock and employs a process which automatically removes risk from the members’ portfolio when volatility rises, by transferring that allocation into lower-risk assets such as cash. The Aegon fund trigger for this transfer is volatility of one percentage point above or below the 9 per cent volatility target.
This tactical asset allocation divides pension providers. Alliance Bernstein head of pension strategies David Hutchins says that the approach is too simplified.
“Historically volatile markets have more often than not been associated with falling markets and less volatile ones with rising markets, however there are no guarantees for the future that this will hold,” he warns.
“A simplistic mechanistic model based only on market volatility can run considerable dangers. Indeed there is a history of mechanistic trading strategies based on too simplistic historical market analysis becoming horribly unstuck as active market participants exploit the unwary investors in them. Mechanistic volatility management has already come unstuck a number of times in recent years as markets boosted by quantitative easing have fallen sharply on several occasions, but without rising volatility.”
Fawcett agrees, saying that volatility readings could give false implications to a mechanistic model.
“Volatility managed funds can get whipsawed. When tapering caused markets to fall a simplified model would have sold out of equities – but then there was a significant rally. Equally in 2009 when default rates were close to the great depression as an investor you needed to make valuation decisions based on less-quantifiable measures.”
But Barclays Corporate & Employer Solutions head of investment proposition Jonathan Parker says that any mechanism that reduces the size of the falls should result in an improved outcome both from a financial and a behavioural perspective for members.
“The concept of having a dynamic process to manage risk is a good one, as volatility tends to increase during periods of market uncertainty and savers including DC pension members do not like to see the value of their investments fluctuate significantly, particularly on the downside,” he explains.
The alternative no different to the methodology private investors apply on their own portfolios – simple asset diversification. Nest study asset correlation in order to successfully blend assets to minimise volatility.
“Effective diversification by asset class, sector and geography should be any portfolio’s first line of defence against market volatility,” agrees Hutchins.
Prior to auto-enrolment it was an approach that too few default schemes adopted. A 2012 DC research paper published by Schroders revealed that the typical FTSE 100 default scheme had not diversified away from pure equity exposure, despite the recent global stock market crash.
Last year, Capital Group released a paper that showed that volatility management was not simply about reducing or increasing equity exposure – but about the type of equities in a portfolio.
“Dividend paying equities have historically tended to be less volatile than higher beta emerging markets and small-cap equities,” reads Glide Path within a Glide Path.
The study recommends target date funds should seek to lower equity volatility as participants age by gradually shifting the exposure toward historically less-volatile, income orientated strategies and away from higher beta stocks.
But even those who champion the human element of portfolio construction are not averse to employing mechanistic models in part.
Nest’s own schemes hold a BlackRock diversified beta fund, alongside other loosely correlated holdings.
“We use the BlackRock fund as a building block, but we are not in the game of tactical asset allocation,” Fawcett says. “We launched Nest at the peak of the Euro crisis. Our approach is to take a sensible amount of risk at all times. Diversification is the most important factor, and although it seems old-fashioned, it is relatively new in DC schemes. It was not that long ago after all that growth stage members were invested in 100 per cent equities.”
This blend of approaches is popular. Alongside asset allocation, downside insurance and with profits funds can also soften the blow, helping to smooth volatility created by risk assets.
“Constant or variable proportion portfolio insurance; embedding guarantees, for example variable annuity, with-profits; and constructing portfolios with securities that have lower volatility than the market as a whole, for example shares in the utilities and consumer durables sectors, can all help to reduce volatility within pension funds,” says Parker.
But these approaches are expensive, and with the pension charge cap deferred but not put off it could be that more default schemes have to implement more than just asset diversification and portfolio insurance in order to keep costs to a minimum for the member.
Investment consultant Redington says that a volatility-control approach not only helps to reduce equity risk, but also keeps costs down too. While mechanistic models do represent a cost to the member, it is negligible compared to downside insurance.
To minimise risk in a DC pension contract trustees are generally required to embed guarantees or make sure a third party taking on the risk that an investment strategy fails to deliver as expected – but this transfer of risk from the individual to another party costs money. While the automated sell trigger may not be fool proof it certainly is cheaper than some alternatives.
In the interest of cost – and keeping risk-averse members on board – it may be then that a blended approach is best.
“As 2008 proved, diversification will not always be enough on its own,” said Hutchins. “Hence diversification should be combined with a risk management tool that understands when market diversification is not working to improve DC outcomes – this is how we manage our target date funds.”