Conventional LDI wisdom rests on two assumptions: that assets in the hedge portfolio will add duration to help match the duration of pension liabilities, and, conversely, that assets in the growth portfolio will generate returns above the growth rate of liabilities and help close any funding gap. While the nomenclature describes the primary purpose of the assets in the respective portfolios, it does not take into full account the assets’ characteristics. For instance, high yield bonds, usually classified as return-seeking investments and assigned to growth portfolios, have an index duration of 4.35 years, a liability-hedging attribute. On the other hand, U.S. Treasuries, mainly considered a pure liability hedge, can play a very important role in mitigating the equity and economic risks of return-seeking assets.
In this article, we demonstrate how labeling investments as purely hedge or growth and creating separate and discrete allocations that fail to account for the mixture of growth and hedging (or “gredge”) features inherent in different assets can artificially constrain allocations and introduce inefficiencies that prevent portfolios from minimizing overall funded status risk. We modeled a wide range of scenarios, varying funded status, return targets, and hedge and growth allocations. Since results were consistent across scenarios, a single model assuming an 80% funded status and targeting a 7% return can capture the main features of our findings.
In EXHIBIT 1, we show the surplus volatility of six portfolios: a holistically constructed portfolio and five others—bucketed portfolios that have optimized their hedge and growth portfolios separately without accounting for gredge factors (mainly the potential in their liability-hedging assets to reduce investment risk in the growth portfolio).1 The portfolios consist of 40% hedge assets and 60% growth assets and differ only in how they apportion allocations within each bucket, which will affect funded status volatility. We constrained the models still further to conform to real-world investment limitations.
We held allocations to alternative assets—private equity, real estate and hedge funds—to no more than 5% each and the total allocation to extended credit to 15% in all six portfolios.
Comparing the portfolios according to the asset class returns and volatility projected in J.P. Morgan’s Long-Term Capital Market Assumptions for 2016, we found that even with limited room for divergence, the gredge-aware holistic portfolio reduced annual funded status volatility by 20bps on average. The Treasuries in the liability-hedging bucket have correlation tendencies that enable them to perform a dual role. In addition to correlating strongly to plan liabilities, they tend to correlate negatively to the equities in the plan’s growth bucket. So by tilting toward Treasuries in its hedge portfolio, a plan can dial up the potential in its growth portfolio without compromising its hedge ratio or adding surplus volatility. In this fashion, the model can allocate more to high-volatility, high-return assets and achieve the 7% growth target while reducing volatility overall.
By contrast, separate growth and hedge portfolio optimizations lead to an over-allocation to U.S. long credit and an underallocation to U.S. long Treasuries, in large part because the portfolios do not seek to mitigate the economic risk embedded in return-seeking assets—a key gredge benefit. The growth buckets also suffer from biases in the five bucketed portfolios. They under-invest in public and private equities because they hold fewer Treasuries to hedge economic risk. And they overinvest in real estate and hedge funds as a result, because real estate and hedge funds generally carry less economic risk— with a lower upside—than equities.
EXHIBIT 2 looks at the allocations close up. The sharpest distinction between the holistic and the bucketed portfolios lies in their hedge allocations. While the holistic portfolio is more or less evenly balanced between U.S. long credit and Treasuries, the bucketed portfolios have a minimal allocation to Treasuries. Their credit overweight compels them to trim their economic risk exposure—and, as noted, their return potential. They average an 8% lower allocation to equities than the holistic portfolio, compensated for by a 5% greater allocation to real estate, plus 3% more to hedge funds. These are not radical portfolio adjustments, but they do underscore the fact that a bucketed approach generates less efficient portfolios.
THE DURATION PLAY
A major part of the efficiency gained by the holistic approach comes from its ability to meet the 7% return target while investing in U.S. long Treasuries, which are modeled as lower return and higher-duration assets than U.S. long credit. The proxies we used to model the two fixed income assets—the Barclays U.S. 20+ Year Treasury Bond index and the Barclays U.S. Long Credit A index—have shown a consistent difference in duration over time. (As of December 2015, their durations were 18.5 and 13.8 years, respectively.) Since the holistic portfolio allocates more to Treasuries, its duration is 0.75 years higher than the average of the five bucketed portfolios.
The Treasury tilt is not the only route to added asset duration, however. Our bucketed portfolios could lengthen duration to the same extent and gain efficiency with a modest allocation to a Treasury futures overlay. According to our models, if the “bucket brigade” allocated 4.5% of its total assets to futures, it could achieve the same duration as its holistic counterpart and reduce portfolio risk.
DON’T OVERLOOK THE GREDGE ADVANTAGE
In examining Treasuries’ role in enhancing the holistic portfolio’s efficiency, we do not mean to underestimate the utility and value of extended credit. We found that the allocation to high yield and emerging market debt maxed out at the 15% constraint under both construction methodologies. The result is especially noteworthy because many plans do not use extended credit to its full capacity.
This is both ironic and a missed opportunity, for extended credit is the quintessential gredge asset. It adds portfolio duration and offers a potential rate of return in excess of liability growth. In short, extended credit is an asset class that today’s plan sponsors should get to know and consider adding strategically to holistic portfolios.
This excerpt was from 1Q2016 issue of J.P. Morgan Asset Management Pension Pulse
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