Now the peak of the first wave is over and liquidity fears have ebbed away, trustees are stepping back and thinking about how to position their fund’s portfolio for the new normal.

 

As markets slid in reaction to the pandemic in February and March, schemes were prioritising the most immediate matters. 

 

“The focus was making sure you could keep the operational stuff going, post collateral for LDI and pay pensioners,” says Keith Scott, a trustee director at LawDeb Pension Trustees.  

 

With governments unlocking and everyone gradually having got used to video calls, people are now returning to dealing with other business and looking at what to do with their portfolios – particularly given recent rallies in US equities, says Scott. 

 

 

But as the divergence between capital markets and the economy continues to puzzle investors, there are differing interpretations of what this means.  

 

“The general theme is derisking out of equities,” finds Dalriada CIO Simon Cohen, as in the views of many, economic reality will eventually catch up with capital markets – recent news about Japan posting the worst economic result on record could serve to reinforce that view. 

 

“A lot of clients are cautious about what markets are saying versus what is happening in reality,” he notes. Assets are being moved towards diversified fixed income instead, he says, and potentially some hedging, as liability-driven investment has become slightly cheaper. Investors are “also just looking for diversification across growth assets”, he adds, such as infrastructure and private equity. 

 

However, for most clients the focus has been around ESG, says Cohen, given that statements of investment principles have to be updated and published from 1 October this year and funds will need to follow this up with implementation statements. 

 

Some schemes are therefore now looking at the different funds and strategies available. Those who hold passive equities, for example, might change that for an investment in a climate tilt index.  

 

“It's like the first step in taking ESG more seriously because it’s quite easy to do,” says Cohen. However,  on the whole, assessing managers is difficult because the market is only developing, he finds. “There are not huge number of funds, and there is greenwashing going on. It‘s not an easy task finding a fund,” he says, adding that the industry as a whole is still only developing an ESG skill set. 

 

The case for ESG has become stronger with the performance of such funds during the crisis, notes Robert Wayne Fitzgibbon, head of DB investments at consultancy Mercer. 

 

 

Many schemes have also used this time to stress test their portfolios or look for opportunities in credit markets, Fitzgibbon observes, adding that the next big buying opportunity will come with the dislocations from the wave of company defaults once government support schemes end. 

 

The apparent disconnect between the economy and stock markets is on everyone’s radar, he agrees, but although the market rally is surprising, Fitzgibbon disagrees with the idea that the equity market is completely irrational.  

 

“[It] does actually make sense if you think about it,” he argues, because the companies that dominate haven’t been as affected by the crisis. Much of the pain from lockdown is confined to some sectors and to small and medium businesses rather than blue chips – a number of which have actually profited from Covid-19, he says. 

 

 

As the economy is being reset, government stimulus seemingly endless and yields close to zero, will pension funds need to rethink LDI? “It is time to look at liability hedging,” Fitzgibbon proposes, noting that “the market has been obsessed with interest rate risk”. 

 

In the next decade or so, this could change – and inflation might be the biggest threat to pension funds once more. Although “some people are too alarmist”, he says there are many arguments speaking for a rise in inflation, such as deglobalisation, including events like Brexit. “The balance of risks has got to be towards inflation creeping up,” he believes, and although this will happen slowly, an increase of 1-2 percentage points could have a big impact on schemes.  

 

There is added uncertainty around inflation because of the government’s plans to change RPI and put it in line with the lower CPIH, which would alter the value of index-linked gilts as well as some scheme liabilities. The change is a particular concern for schemes that have a portion of benefits linked to CPI, which many of them do, says Ian Mills, partner and head of DB endgame strategies at Barnett Waddingham. Some schemes are therefore thinking about tactically underhedging inflation risk, he adds. 

 

However, “the key point is that those schemes that have hedged [inflation and interest rate] risks have held up well; for those that haven’t, the trend to hedging continues but in a pared back way”, he says.  

 

When it comes to interest rate hedging, the “relentless” move towards LDI over the past 15 years or so could slow down, he feels. Given that yields are close to zero, those who argue that they cannot fall further are becoming more vocal, he agrees: “We are starting to see the emergence of the discussion on whether risk is asymmetric and schemes that have fully hedged liabilities want to express a tactical view by wanting to reduce their hedge a little bit.” 

 

 

Overall during the crisis, schemes have fared differently depending on how far away they were from their long-term goals when markets fell, agrees Emily McGuire, a partner at consulting firm Aon. At the moment, “we are seeing responsible investment throughout the client base, and the credit piece featured heavily”, she says. 

 

The crisis has also shown where there are weaknesses in investment governance, with speed being essential when markets fall. As a result, more schemes are considering taking on a fiduciary manager for the first time, whether for a part mandate or full delegation. “One of the themes that have come through has been being able to be nimble,” she notes. 

 

Keith Scott

Simon Cohen

 

Robert Wayne Fitzgibbon