This summer’s China crisis has put volatility controls to the test. Philip Scott finds modern defaults holding up well
Following a prolonged period of relatively benign market conditions, investors were reminded again in August of the cruelty of equity volatility as billions were wiped off the value of investments.
Global markets endured their worst collapse in years, chiefly as a result of China’s tinkering with its currency and slowing economic growth, which together sent shockwaves through world markets.
The upshot was a rise in correlations across risk assets with equities, credit and emerging markets all exhibiting vulnerabilities.
The month saw a level of volatility not seen since the days of the financial crisis. In the space of a fortnight, £160bn was wiped off UK stocks as the FTSE 100 entered technical correction territory, having nosedived by more than 10 per cent from its April high of 7,122.
While investors were given some respite as shares rebounded in the final days of August, they were still left reeling. In all, the FTSE 100 closed the month 6 per cent lighter while the US S&P 500 punched in a 5 per cent drop, according to FE Analytics.
Global equities overall, as measured by the MSCI AC World Index, were off by more than 5 per cent while China suffered an extremely sharp fall, with the Shanghai SE Composite down a massive 14 per cent as investors dumped shares in droves. And some experts believe there is considerably more bad news to come.
Surveying the recent market behaviour, Master Adviser independent financial adviser Roy McLoughlin says: “Weeks such as those just gone are a fascinating insight into the pension world and fund selection.
“What is clear is that pension funds are affected by geopolitical situations and today’s pension and investment advisers need to be aware and prepared for the calls in a way that they never
have been before.
“With the imminent explosion of drawdown, this becomes an even more important point.”
But volatility is part and parcel of investing in the stockmarket. Pension funds – and especially default schemes – by design are created to endure market knocks with many employing volatility controls in order to cope during rocky periods.
Hargreaves Lansdown head of corporate pension research Nathan Long notes that volatility controls in default funds were introduced by some providers to coincide with auto-enrolment.
He says: “Whether this strategy is needed is a moot point. The volatility targets used in these off-the-shelf default funds are often very similar to the long-term volatility of default funds used before auto-enrolment.”
For example, Long notes that the annualised volatility of the ABI Mixed Investment 40-85 per cent Shares sector over 20 years is 10.74 per cent, according to Lipper.
Looking at how the arrangements currently in place are standing up to the volatility from the China crisis, Buck Consultants at Xerox investment consultant Alison Lewis asserts that diversified strategies have generally provided a degree of protection. She adds that funds with high levels of equity exposure have been impacted the most – but these tend to be used only where members are many years from retirement, or as high-risk options for more adventurous investors.
Lewis says: “Pension scheme members are long-term investors and default funds are designed with this in mind. However, volatility acts as a useful reminder of why default funds should take a diversified approach – and, in particular, why it is important to provide members with ‘safer’ options as they approach retirement.”
For its part, Buck implements a form of ‘consolidation’ fund in the de-risking phase for many clients. This helps reduce volatility while still aiming for some growth, thus leaving a member’s options open to use their pension account as they see fit at retirement.
But prior to the recent market upheaval, fund managers appeared to be anticipating some sort of correction. Given the rally that global equities have enjoyed since the nadir of the financial crisis, many schemes had been adopting a more defensive stance.
AllianceBernstein head of pensions strategies UK David Hutchins says: “The days of ‘set and forget’ in pensions investment are long gone. For instance, we have been reducing our equity market exposures across all our UK pension strategies over the past few months in order to shore up our defences in advance of a potential market fall.”
Many funds, despite enduring losses, managed to keep the situation relatively under control. For example, Friends Life’s My Future Growth fund fell by 3 per cent during August while Aviva’s Diversified Assets Fund II shed nearer to 4 per cent.
Looking at how Aviva handles such market wobbles, head of corporate propositions Matt McGill explains that the default funds have volatility targets built into them that are designed to work over the long term. These were introduced to provide members with a smoother journey compared to investing 100 per cent in equities in the early or accumulation/growth phase.
McGill says: “During this phase, we are trying to balance the need to grow the value of the member’s savings while limiting the extent to which those savings are exposed to large fluctuations in value. As members get closer to their retirement date, the default solution reduces their exposure to equities, so shielding members’ savings from the full brunt of the volatility seen in markets over the past few weeks.”
Standard Life Investments investment director David Bint says the group’s Enhanced Diversified Growth fund has taken a similar stance. The portfolio aims to generate equity-type returns over the economic cycle – typically five to seven years – but with less than two-thirds of equity market volatility. He says: “We have been reducing our equity allocation; it has fallen from about half to a third in the past six months or so. It fell by 3 per cent in August.”
Of course, for members many years from retirement, short-term fluctuations in the value of their investments are of less importance because they have time to make good any losses. Default funds are designed to provide protection for members as they approach retirement by switching into lower-risk asset classes.
Post-retirement, members who have purchased an annuity have peace of mind from the knowledge that their regular income will not be affected by market volatility. But members who have opted not to convert their funds may see their pension account fall in value, reducing the level of income they can take from it.
Lewis says: “Anyone investing post-retirement needs to carefully consider their capacity for loss as a fall in value in the first few years of retirement significantly increases the probability of running out of money later on.”
When it comes to the retirement phase, Long says he has been encouraged by the awareness of members about the fall in global stockmarkets. Rather than panic, some people have actually increased their regular contributions to take advantage of the fall in the market.
Members who have recently accessed drawdown may of course be sweating following the recent drop in global stockmarkets but the extent of any impact is dependent on the strategy employed.
As Long points out: “Those drawing capital – which means selling investments to fund the withdrawal – will be selling investments at a low point and may do irreparable damage to their pension plan. Those who are drawing investment income, where the underlying investments remain intact and the income from dividends or bonds is used for the withdrawal, could be largely unaffected.”
Calling the market
Fund manager BlackRock elected to use cash allocations and hedging strategies in recent months. Diversified Growth portfolio manager Adam Ryan says the team added to cash because it expected volatility to increase and the diversification benefits of holding government bonds to be muted.
Ryan adds: “While having strong risk management processes and tools is vital in such periods, it is also important to retain a forward-looking, pragmatic and active approach to asset allocation. This is because correlations are unstable and no market crises are ever the same. We therefore avoid relying on historical assumptions around correlations or being over-reliant on historical data; we combine quantitative inputs with the judgement of our research teams.”
As a result, the firm’s newly launched BlackRock Dynamic Allocation fund stayed ahead of the market, falling by 3 per cent in August.
“While there was little help from fixed income exposures, cash and hedging strategies helped cushion the negative impact of holding exposure to risk assets,” says Ryan. “For investors that allocate to the strategy in their default, the strategy will have provided a useful tool for dampening volatility in August.”
State Street Global Advisors senior defined contribution strategist Alistair Byrne says the group’s Dynamic Diversified fund moves between growth and defensive assets depending on the market volatility environment, while its Target Volatility Triggers strategy de-risks from equity to cash when market volatility exceeds the target trigger level.
Both mechanisms are used in the group’s flagship Timewise Target Retirement funds to manage risk. Its MPF Timewise Target Retirement 2020 fund, for example, shed 3 per cent during August.
“The events in China have led to increased volatility and both mechanisms are taking a more defensive stance to limit downside risk for members,” says Byrne.
“Trustees and sponsors also prefer lower volatility and a narrower range of outcomes for their scheme members.
“We think it is important to make meaningful changes in asset allocation to reflect market conditions. Market volatility tends to be persistent and there is more chance of large losses during volatile periods.”