Advances in managing pension asset volatility.

• Author: Bonsee, Paul
• Position: Benefits

Aprofound shift is taking place in the way pension plan fiduciaries manage market risk and help participants save for retirement. It is being driven by strategies that go beyond asset allocation and seek to actively account for changing market conditions, striving to protect growth in bull markets and defend against losses during major downturns.

Historically, most attempts at managing portfolio risk have relied heavily on asset allocation--diversifying exposure among asset classes that have exhibited low correlation to one another. This theory, however, has proven ineffective at certain points in time, especially when the economy is contracting.

In 2008, for example, nearly every major asset class was affected by the global downturn: U.S. equities were off 37 percent, international equities were off 45 percent, emerging markets were down 55 percent, real estate was down 37 percent, high-yield bonds lost 26 percent and commodities were down 37 percent.

Even hedge funds and private equities, which generally promise market outperformance, performed poorly. Alternative asset classes posted an average loss of 19 percent during the recent financial crisis.

Many experts believe the high correlation across many of the world's major asset classes was not a black swan event, but rather the inherent reaction of evermore-connected global economies. Additionally, broad access to historically successful "diversifies" such as commodities reduced the correlation benefit that was once thought innate in such asset classes.

This played out during the months leading up to the 2008 crisis, when the market witnessed billions of dollars flow into newly created commodities-based, exchange-traded products that offered easy one-click access to a world previously available only to large institutional investors. In the months following the financial crisis, when many institutions and investors needed to raise capital to offset losses or simply fly to safety, a massive outflow in the commodities-based products caused the asset class to sell off in lockstep with many of its "low-correlated" counterparts.

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When Evolution Meets Revolution

Since the 1952 publication of Harry Markowitz's article; Portfolio Selection, investors have relied on asset allocation strategies to reduce portfolio risk. During the economic booms, the success of diversification was praised. During the busts, its validity was questioned.

Though at the time of its writing Portfolio Selection was revolutionary, the world and its economies have evolved dramatically over the past 60 years. One example came through the development of financial futures contracts in the 1970s, which have provided institutional investors the ability to develop sophisticated hedging strategies to effectively mitigate market risk. Today, the financial futures market is one of the most transparent and liquid markets in the world, accounting for...