Now What? Why Now Is Not the Time to Abandon Your Asset Allocation Process
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Capital markets are in disarray in reaction to the coronavirus crisis and the necessity of pausing the global economy. The CBOE Volatility Index (the VIX) rose to over 80 in March and thankfully has settled down to a level of about 35, which is still over twice its trailing five-year average of about 15. Markets are buffeted by each day's new news, guesses about infection rates, potential medical solutions and the adequacy of economic policy intervention. Equities have recovered a bit from their bottom, but are still off about 14% for the year. U.S. Treasury yields fell to all-time lows and, as often happens in times of great uncertainty, long corporate spreads—upon which corporate pension liabilities are based—blew out, increasing from about 140 basis points (bps) to 350 bps and then drifting back to about 250 bps.
Investors are reeling. Money managers see great opportunity. And our clients are asking …. now what? In other words, don't just stand there. Do something. Thankfully, most of our clients had a plan for that.
Plan the work. Work the plan.
The beauty of a well-constructed asset allocation policy—informed by an investor's near-term cash needs, long-term requirements for benefits payments and an understanding of long-term relationships among asset classes—is that such a policy allows one to not just do something, but to simply stand there. Developing such a strategic policy and enforcing it not only avoids the temptation to react in the heat of the moment, but is the hallmark of a disciplined investment program. Unless cash needs, long-term requirements, or long-term relationships have fundamentally changed, that's the plan.
In the heat of the moment, however, it is very hard to ignore the feeling that things might have changed, that things might get even worse and you should become defensive, or that the market has over-reacted, there is opportunity and you should become more aggressive. But one reason you identified an asset allocation policy based on long-term relationships was that you accepted the common wisdom that it's very hard to time the markets. Well, if you didn't believe you could time the markets then, why do you think you can time the markets now, in the midst of chaos?
Most investors need return-seeking assets such as equities, which offer higher return at higher risk as a means of filling the gap between the assets—plus contributions—and the liability. The asset allocation reflects a balance between the needs and desires for higher return while trying to hedge away as much of the liability risk as possible. The liability interest rate risk has two components: treasury risk—which is fairly easy to hedge—and spread risk—which is difficult, if not impossible, to hedge¹.
Treasuries or credit or…?
A complication is that spread risk is correlated with equity risk. This correlation rises in times of great uncertainty, like right now. This association between the return-seeking portfolio and the liability itself means the investor must adopt a total-portfolio perspective and avoid focusing on either the structure of the hedging program or of the return-seeking assets in isolation.
In calmer times and over longer horizons, Treasuries comprise most of the risk—and return—of the liability. Credit spread typically accounts for little of either risk or return. Therefore, many plans hedge much of their liability risk using long Treasury bonds. Treasuries have several additional advantages. They are available in longer maturities than long corporate bonds and therefore can hedge a greater proportion of the liability per dollar of investment. They are more liquid, easier and cheaper to buy and sell, and less expensive to manage within a portfolio. Finally, during episodes of flight-to-quality, where equities are highly volatile and falling, Treasuries are the assets to which equity investors flee. In 2020, as equities fell 21% (through March 31), long Treasuries rose 21%. As a result, Treasury yields are near all-time lows and credit spreads are very high, though still well below the highs of the Global Financial Crisis (GFC). Spread yield now comprises two-thirds of the discount rate and spread return risk is about two-thirds of the overall risk of the liability. Clients are wondering—is it time to shift from Treasuries to credit in the hedging portfolio?
While it is now true that Treasuries are not a great hedge for the liability—since most of the risk is now associated with the spread—they were never a perfect hedge. Treasuries were and still are a nearly perfect hedge for the treasury component of the liability. Treasuries will probably also continue to serve as a safe asset in these volatile markets. The spread exposure of long corporate bonds was—and is even more so now—a sloppy hedge¹ for the liability spread risk. Spread risk is also very highly correlated with equity right now. Our risk model suggests there's a 20% chance that both equity and spread return will be greater than 10% over the next year. The model also suggests there's a 20% chance that both spread and equity will be worse than -10%. In other words, there's a 40% chance that things will be … exciting. From a total-portfolio perspective, it's not a Treasury/credit decision, but rather a credit/treasury/equity decision.
By comparing risk/reward frontiers based on typical conditions with those based on current conditions, we can make a strong case for shifting from a mixture of Treasury and equity to a totally different mix of equity and credit, which would greatly reduce risk for the same level of expected return. We can also make a strong case for shifting from Treasury to credit to gain higher expected return for the same level of risk. But why now? Or why change it up now and not always or regularly? When—and why—will you change it up again? Have things permanently changed or is this temporary? If temporary, then a shift now is an attempt to benefit from a difference between current and longer-term conditions, which is market timing.
There is no sometimes
We believe a truly dynamic approach to asset allocation policy can be successful. I've tracked several simple systematic dynamic allocation strategies for over 10 years, when this credit/treasury question came up during the global financial crisis (GFC). These strategies would have performed extremely well relative to traditional policies over most time horizons (both before and since the GFC). But these strategies involve dramatic shifts in allocation (between equity, treasury and credit) and are effective only if implemented consistently through time, much less so if implemented sporadically. Should you adjust portfolio allocations in response to current conditions? I'm reminded of Yoda … "You must unlearn what you have learned. Do, or do not. There is no sometimes."
If you think you can time the markets, why did you adopt a strategic policy allocation, thereby constraining your ability to do so?
If you don't think you can time the markets during calmer times, then why now, in the midst of chaos?
Eventually, I would love to see investors, advisors, and consultants abandon the notion of a fixed strategic allocation in favor of a systematic dynamic strategic policy which adjusts allocation based on current conditions. Some of our clients already adopt a target-return approach, which shifts the exposure among return-seeking assets as near-term return expectations change. Clients also modestly shift LDI portfolio duration to focus on liability hedge ratio targets. However, doing so requires adjustments to benchmarking, evaluation of different approaches, even changes to governance policies. Given the extreme uncertainty we face in the marketplace today, now is NOT the time to decide to adopt a different approach to asset allocation.
¹ While liabilities are valued using yield curves based on corporate bonds, these bonds are often a poor hedge for the liabilities due to the asymmetric impact of defaults and downgrades. When a bond defaults or is downgraded (and drops out of the sample), the assets suffer. However, prior to default/downgrade such bonds are usually at the upper end of the yield distribution within the sample so when they drop out, the yield curve actually drops – which causes the liability value to increase. The drag associated with this asymmetry has been estimated at 35bp to 100bp per year, much higher during crises like the GFC.
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