17 December 2020
I’ve been advising institutional investors since 1993, so I have seen a few crises since then and each has thrown up different opportunities for learning and reflection, as well as re-enforcing the three timeless themes below.
“Prepare for the Worst, Plan for the Best”
From a market perspective March 2020 felt in many ways similar to September 2008, except this time many more investors were better prepared. Nobody expected a global pandemic, but my key takeaway from this very difficult year is that disciplined risk management really does work.
For example - defined benefit pension schemes that had assessed and managed the key investment risks such as interest rates, inflation, equity and credit risks maintained very stable funding positions throughout the period and have remained on track to achieve their long-term objectives and have avoided many difficult discussions as a result.
Any trustees who have had moved to near 100% hedge ratios for a number of years must be especially relieved. For almost as long as I can remember clients have said to us: interest rates look incredibly low, is it really a good idea to buy government bonds and hedge interest rate risks? Our answer has generally been “yes” and I believe 2020 has continued to show that those who are able to accept the world as it is, not as they think it ought to be, are rewarded. It is not a good investment strategy to be waiting for interest rates to revert to some previous level you have in mind.
In contrast, any pension funds who had left these key risks in their portfolios have suffered badly and remain in a difficult position. When the markets were in steep decline in March, many of the affected sponsors and trustees were asking what actions they should take to protect their position. Unfortunately, it was already too late, and the damage had been done – the time for action was before this unexpected event occurred when conditions were stable.
I believe some DB pension schemes were running too much risk pre-Covid, as a result of a strong covenant assessment of the sponsor. However, the covenant is a single spot assessment of strength and risk associated with a single business (not diversified like an asset portfolio) and, as 2020 has highlighted, an unexpected risk event can cause havoc to any company whilst leaving others unscathed or even better off.
So, a simple takeaway from Covid for any Trustee with a strong covenant is, I would suggest, to also consider what investment strategy and risk levels you would run in your investment strategy if the covenant assessment was weak. This may bring out whether too much reliance is being placed on the covenant remaining strong and whether further risk mitigation actions should be taken.
Have enough liquidity
Any decent consultant will tell you to have enough liquidity but another important theme I have seen is that it's always better to have too much liquidity than too little. Two reasons: firstly, for unexpected events that can always occur (for example a significant unexpected cash requirement) and, secondly, to enable you to exploit attractive market opportunities when they arise.
As Warren Buffett said, “Be greedy when others are fearful”. April was an ideal time to add equity or credit exposure and several of my clients were able to do this by having plenty of liquidity and the right structure to enable quick implementation. In particular, those that had bespoke liability hedging arrangements were able to add synthetic equity or credit overlays swiftly and with very low transaction costs. The benefit of this quick action was many millions of additional pounds. Having excess liquidity made the decision-making process very easy.
Beware of the flavour of the month
My final reflection is regarding the recent “flavour of the month” investment approach of focusing solely on contractual income assets to generate the required asset returns (sometimes called cashflow-driven-investment or CDI).
This year has shown how “contractual” definitively does not mean “guaranteed”. There are many examples of this, from long lease property funds not receiving rents and marking down some assets by 50% to private credit funds having several defaults, some of which have seen the value of the loan written down to zero.
I believe contractual assets do have a place in a portfolio but not to the exclusion of everything else. For decades, pension schemes have benefitted from the capital growth of equities and other assets rather than relying just on income and I believe this should remain the case. Very unexpected events can and do occur and effective diversification really helps to mitigate the impact and potentially enables long-term outcomes to be achieved well ahead of time. Let’s plan for the best for the future and reap some capital growth!