Partner Article

The Case for Hedged Equity

If any of the questions below are important to your pension scheme – we think it is worth a few minutes of your time to read this post: · Is my pension funded status lower than I would like it to be? · Is my scheme on a “de-risking” glidepath? · Have I been disappointed with the performance and fees of equity long/short hedge funds? · Are equity markets overvalued?

In order to address the above, pension schemes need to address the primary risk to their return-seeking portfolios – equity risk. Today pension schemes are already diversified across several asset classes (including public equity, private equity, real estate, high-yield bonds and others), but the primary risk factor across all these asset classes is equity risk. How can pension schemes prepare for the next equity fall?

For calendar year 2020, global equity investors were handsomely rewarded for staying-the-course; returning over 16% despite the Covid pandemic and a challenging global economic outlook. Looking ahead into 2021, identifiable downside tail risks persist while knowing the timing of the next downturn remains difficult because it appears :

· Equity valuations are high on a historical basis using traditional metrics · Success of the current Covid vaccine coupled with the uncertainty of the new Covid strains remain · Equity risk remains disturbingly high despite the recent market rally · The current equity market rally was driven by an increase in government and central bank borrowing, which was then translated into “free money” for (almost) everyone – this dynamic may delay the next equity market downturn for longer than one may think

We believe pension schemes require the long-term returns from equities to achieve their long-term investment objectives, while at the same time taking into consideration the risk of a near-term equity downturn. We believe hedged equity is an asset class that is the right solution to this problem in the current environment.

What is hedged equity? Hedged equity products allow schemes to continue to participate in rising equity markets whilst reducing exposure to falling equity markets whenever they may occur. Hedged equity strategies attempt to provide investors consistent protection against falling equity markets while providing varying levels of upside equity market participation. In reviewing and differentiating among hedged equity strategies, there are four main areas to consider:

· Target level of equity protection – if the equity market falls significantly, how much less is the hedged equity strategy expected fall · Certainty of equity protection – when the equity market falls significantly, what level of confidence does the manager have that the hedged equity strategy delivers equity protection · Cost of equity protection – protection is not free (or cheap)! What is the expected annual cost for equity protection over a full market cycle · Reducing the cost of protection – what range of strategies does the manager use to reduce the cost of equity protection

How do pension schemes frame the decision to allocate to hedged equity strategies and achieve approval from Trustee boards? Ultimately, there are one of two time horizons pension schemes consider when implementing equity downside protection:

· Long-term: a need for long-term exposure to the equity markets for return generation, but with a lower tolerance for the potential downside losses (for example a pension scheme with a weaker sponsor covenant) · Short-term: an expectation that markets will continue to rise over the long-term but with an increased likelihood of a market correction over the short-term (for example concerns over-stretched equity valuations, state of the broader economy)

In our opinion, the best way to manage significant equity declines is to be prepared and the current crisis served as a crucible to test the efficacy of hedged equity strategies. We believe hedged equity is a timely addition to a diversified portfolio allowing pension schemes the opportunity to outperform during the next equity market drop while continuing to benefit from the long-term returns offered by the equity markets.

This was posted in Bdaily's Members' News section by SECOR Asset Management .