Pension funds’ hedging dilemma
Pension funds have no shortage of concerns: their funding deficits are rapidly growing in the current low-return environment, and ageing populations are stretching their liabilities.
But a recent survey of pension funds trustees by French business school EDHEC has found that their biggest worry, cited by nearly 77% of the respondents, is the risk that their sponsor — the entity or employer that administers the pension plan for employees – could go bust. Yet 84% of respondents fail to manage the sponsor risk.
So how do you hedge against such a risk?
You could buy credit default swaps of the sponsor company or buy out-of-the-money equity put derivatives to seek protection. But both options are costly and illiquid. Moreover, it might send a negative signal to the market: after all, if the company’s pension fund is seen effectively shorting the company in an aggressive manner, investors may wonder “What do they know that we don’t?”
Erwan Boscher, head of Liability-Driven Investing and Fiduciary Management at AXA Investment Managers, says:
“Using market instruments like CDS and out of the money equity puts were suggested as a way of hedging sponsor risks, but we seldom see them implemented because of the cost, liquidity or reputational risks for the sponsor.”
Market exhaustion?
It’s curious to see so many asset managers reaffirm their faith in a bullish 2012 for world markets just as a buzzing first quarter comes to a close on Friday with hefty gains in equities and risk assets. Whether or not there is a mechanical review of portfolios at quarter end, it’s certainly a reasonable time for review. The euro zone crisis has of course eased, the ECB has pumped the banks full of cash and the U.S. recovery continues. So, no impending disaster then (unless you subscribe to the increasingly-prevalent hard-landing fears in China). But after 11+ percent gains in world equities in just three months on the back of all this information, you have to wonder where the “new news” is going to come from here. The surprise factor looks over and we’re highly unlikely to get 10%+ gains in global stocks every quarter this year. So, is it time for tired markets to sober up for a while or maybe even reconsider the risk of reversal again? Strategists at JPMorgan Asset Management, at least, reckon the economic news has just lost its oomph.
There are broad signs of exhaustion in markets, which is coinciding with a softening in the data, suggesting that in the short term the moderation in the “risk on” environment may continue.
JPMAM cite the rollover in the Citigroup economic surprises indices, shown below, and also say their own propietary Risk Measurement index — a 39-factor model built on data from money markets, equities, economic data, commodities etc — is flagging more caution.
Time for a pause and bit of a think then, at least until the first-quarter corporate earnings season kicks in next month. And it’s here the next leg of any equities story may have to play out, rather than in the corridors of central banks and finance ministries. Gavyn Davies, Fulcrum Asset Management chairman and formerly BBC chairman and Goldman Sachs economist, reckons the valuation case for equities is pretty strong after a lousy decade — even if government bond yields continue rising. What’s less certain, he says, is whether the historically high share of nominal GDP commanded by after-tax corporate profits can persist. This requires a paradigm shift, one he reckons is bridged by globalisaton trends. One quarter won’t solve that puzzle, but attention may shift in that direction over the coming weeks.
Three snapshots for Thursday
The VIX volatility index has fallen below the average level seen during the 2003-2008 pre-crisis period.
The low level of the VIX is also being matched by moves down in other ‘safe haven’ assets. The dollar is near an 11-month high against the yen, and a rise in U.S. Treasury yields is pushing up the spread between U.S. and Japanese bond yields.
President Barack Obama and British Prime Minister David Cameron discussed the possibility of releasing emergency oil reserves during a meeting on Wednesday, two sources familiar with the talks said.
While likely to be popular with many Americans, tapping the SPR alone could antagonize allies in Europe, several of whom remain unhappy over last year’s action and are unlikely to back another release.
The head of the Paris-based IEA, Maria van der Hoeven, has said in recent weeks she sees no current need for consuming nations to release strategic reserves.
Emerging Markets: the love story
It is Valentine’s day and emerging markets are certainly feeling the love. Bank of America/Merrill Lynch‘s monthly investor survey shows a ‘stunning’ rise in allocations to emerging markets in February. Forty-four percent of asset allocators are now overweight emerging market equities this month, up from 20 percent in January — the second biggest monthly jump in the past 12 years. Emerging markets are once again investors’ favourite asset class.
Looking ahead, 36 percent of respondents said they would like to overweight emerging markets more than any other region, with investors saying they would underweight all other regions, including the United States. Meanwhile investor faith in China has rebounded with only 2 percent of investors believing the Chinese economy will weaken over the next year, down from 23 percent in January. China also regained its crown of most favoured emerging market in February.
Last year, the main EM index plummeted more than 20 percent as emerging assets fell from favour. So what is the reason for this renewed passion in 2012?
Firstly December’s LTRO — a multi-billion euro liquidity arrow from the cupids at the ECB has revived investor appetite for riskier emerging assets, boosting the index to around six-month highs since the start of the January. A second significant factor behind the resurgence in risk sentiment is that the market is daring once again to hope for an improvement in global growth, says Gary Baker, BofAML Global Research head of European equities strategy.
The big beneficiaries of all this have been emerging markets. It’s not just about liquidity. Clearly the actions of the ECB have been vitally important… but what you’ve also seen is an improvement in global growth optimism. If optimism over growth is improving then there may well be a more fundamental underpinning to the movement.
So is investors’ new-found love for emerging assets a passing flight of fancy or a true sign of commitment?
The significant monthly improvement in market sentiment towards emerging markets and the 44 percent level of investors overweight emerging markets are both events which have historically coincided with short-term underperformance by emerging equities, Baker says.
Currency hedging — should we bother?
Currency hedging — should we bother?
Maybe not as much as you think, if we are talking purely from a equity return point of view — according to the new research that analysed 112 years of the financial assets history released by Credit Suisse and London Business School this week.
Exchange rates are volatile and can significantly impact portfolios — but one can never predict if currency moves erode or enhance returns. Moreover, hedging costs (think about FX overlay managers, transaction costs, etcetc).
For example, the average annualised return for investors in 19 countries between 1972 (post-Bretton Woods) to 2011 is 5.5%, hedged or unhedged. For a U.S. investor, the figures were 6.1% unhedged or 4.7% hedged (this may be largely because only two currencies — Swiss franc and Dutch guilder/euro — were stronger than the U.S. dollar since 1900).
“The impact of hedging on returns (as opposed to risk) is a zero sum game. The profit a German investor makes on Swiss assets if the franc appreciates is offset by the loss the Swiss investor incurs on German assets… Averaged over all reference currencies and countries, the mean return advantage to hedging both equities and bonds was zero, both over 1900-2011 and 1972-2011.
LBS’ Elroy Dimson and Paul Marsh, who presented the report at a briefing this week, were keen to emphasise hedging has its use. Mainly, it does reduce volatility, hence risk.
However, the study showed that the benefits of hedging on volatility did shrink; On average, hedging reduced equity volatility by 15% over 1900-2011, but by only 7% over 1972-2011. For bonds, the figures were 36% and 30%.
from Davos Notebook:
Groundhog Day in Davos
The programme may strike a different note -- this year's Davos is apparently all about Shared Norms for the New Reality -- but much of the discussion at the 41st World Economic Forum annual meeting in Davos this month will have a distinctly familiar ring to it.
Last January, the five-day talkfest in the Swiss Alps was dominated by Greece's near-death experience at the hands of the bond market and recriminations over the role of bankers in the financial crisis, as well as worries about China's rapid economic ascent and a lot of calls for a new trade deal.
Fast forward 12 months and not much has changed.
Ireland has joined Greece in the euro zone's intensive care unit and Portugal and Spain are getting round-the-clock monitoring. The annual round of bankers' bonuses is once again stirring up trouble. China looms larger than ever on the global stage, after overtaking Japan in 2010 to become the world's second-biggest economy. And trade ministers who signally failed to make headway last year say they really must get down to business when they meet on the sidelines of Davos this time round.
For a sense of the deja vu, take a look at the WEF's latest hot-off-the-press report on Global Risks -- a 50-page tome on the spider's web of interconnected threats now facing the world. Not much progress in addressing them has been made, it seems. Government debt and the danger of sovereign default remains top of the risk hit-list, alongside macroeconomic imbalances, the fragility of the economic recovery and resource limits. It is a very similar litany as a year ago.
Worryingly, while the threats remain all too visible, the report's authors conclude that the world is now uniquely vulnerable to any further shocks in the wake of the financial crisis.
Act now or forever hold your (b)-piece, Obama
It appears the penny has finally dropped in Washington.
Bank bailout watchdog Elizabeth Warren, chair of the Congressional Oversight Panel, has unveiled a report that outlines the perilous state of the U.S. commercial mortgage sector, which left unaided could spark “economic damage that could touch the lives of nearly every American”.
The Havard Law School Professor and her panel colleagues are talking the kind of apocalyptic language that may just shock the White House and its star policy advisers into facing problems banks have now rather simply obsess about those they may or may not encounter in the future.
The global banking system may well need some kind of Volcker-esque guidelines to curb the next generation of excessive risk-takers but critics say Obama is putting the cart before the horse in his efforts to haul the economy back on track.
Certainly, the U.S. government has toiled long and hard to stabilise the U.S. housing market, like propping up Fannie and Freddie and their dysfunctional offspring, but the subprime mess has distracted attentions from the toxic commercial market, where the clean-up task is no less important.
Warren reckons there is about $1.4 trillion worth of outstanding commercial real estate loans in the U.S that will need to be refinanced before 2014, and about half of them are already “underwater,” an industry term that refers to loans larger than the property’s current value.
But some believe bank brains are wasting too much time figuring out how the so-called “Volcker rule” might affect their operations and future profitability, instead of getting their arms around the real estate loans that could snap their institutions in two long before the anti-risk measures even take hold.
has it ever occured to people that the Obama administration is not there to fix anything ? just asking
What worries the BRICs
Some fascinating data about the growing power of emerging markets, particularly the BRICs, was on display at the OECD‘s annual investment conference in Paris this week. Not the least of it came from MIGA, the World Bank’s Multilateral Investment Guarantee Agency, which tries to help protect foreign direct investors from various forms of political risk.
MIGA has mainly focused on encouraging investment into developing countries, but a lot of its latest work is about investment from emerging economies.
This has been exploding over the past decade. Net outward investment from developing countries reached $198 billion in 2008 from around $20 billion in 2000. The 2008 figure was only 10.8 percent of global FDI, but it was just 1.4 percent in 2000.
Not surprisingly, the lion’s share comes from the BRICS — Brazil, Russia, India and China — which together made up 73 percent of outflows last year. BRIC outward investment jumped to $144.3 billion in 2008 from $29.6 billion three years earlier.
Perhaps the most interesting data, however, concerned political risk insurance. MIGA studied the kind of insurance BRICs outward investors were taking to see what kind of things worried them.
Brazil had a mixed of concerns, but Indians were most worried about transfer and convertibility restrictions, the Chinese concerned themseves with war and civil disturbance and Russians were extremely worried about breaches of contract.
Sceptics might be tempted to see this as a reflection of national concerns. But MIGA said it was more micro than that. Russian investment, for example, is dominated by commodity exploration, an area said to be more subject to contract problems than others.
Very thought chewing, stimulating article from your editor on this subject.
I have already written on Brazil,Russia, China, And South Africa!s tremendous survival from the latest worst world recession, and their upcoming markets, economic advantages on many core sectors, increasing trend in trade and commerce, labor productivity and involvement, and adjusted social and economic atmosphere and etc.etc. to this website.
All my writings were published.
After reading of this article, As an economist graduate, voracious reading, keep on writing to major news channels , i have not noticed any set back or any adverse comments from world bank and from any development nations problems in regard to exports, imports, reserved cashes and foreign exchanges from any world quarters.
What have you mentioned on some worries are not any serious concerns for day today positive, encouraging trends are not making any serious threatens by any way.
Hereafter, all many major producing countries will have second thoughts are sidelining of these upcoming countries.
Some examples can be shown here-
Indian economy is growing, profits are showing, production and demand are increasing on road development, ports expansions, steel, gold,silver, and information technology structure are showing very positive, and very encouraging results on day today basis.
The above same good trends are in cards for worlds calendar and for quick introspection for difficult economic conditions to follow or at least to accept a final, real results for their future planning, jobs retaining, jobs creations, awareness towards less expenditure, cost cutting measures, creating more infra structure to their already slow down business.
Still, i can write pages and pages for our users,team and for our world watchers.
If time permits, i will highlight more on these subjects.
To sum up, Nothing to worry from the above developing economies.
from MacroScope:
The end of capitalism
Hard to imagine with financial markets still buoyant and newspapers full of tales of bonus greed, but there is still the possibility that captialism will end. At least there is according to prestigious investment consultants Watson Wyatt in their latest study called "Extreme Risks".
The firm listed the demise of the system of private ownership as one of 15 threats to investors and the global economy that probably won't happen but which it reckons are worth worrying about anyway. The idea behind the report is that such things as climate change, the break up of the euro zone and war are always worth being included in an investment risk management process.
As for the future of capitalism:
In our view, the most likely scenario is moving along from one end of a spectrum where market is king (minimum regulation) towards the other end, where we could see more onerous regulations and government intervention in, and control of, the economy. The extreme risk, however, is the demise of the capitalist system and the end of the market as the primary means of resource allocation.
And the impact:
The economy would be likely to run a higher risk of failure and economic growth would be sluggish in the long run due to lower productivity. Centrally controlled economies tend to be characterised by shortages, which are inherently inflationary. Private investment activities would collapse or even be terminated. The end of capitalism is simply the ultimate extreme risk. The economy is likely to be associated with extreme uncertainty and a large amount of wealth destruction during the transition period.
Watson Wyatt does try to give its free market clients some hope, suggesting that buying gold may be one way to hedge against the propect of capitalism's demise. But it admitted that in such a circumstance investors would probably be more concerned about the return of their investments rather that the return on them.
I’m probably wrong but, hasn’t true capitalism been dead for nearly 100 years now if not more?
Calpers’ appetite for risk
Claudia Parsons of Reuters and Calpers Chief Investment Officer Joe Dear discuss the pension fund’s appetite for risk on CNBC, after a Reuters investigation into how Calpers is delving further into alternative investments despite suffering heavy losses.
More on Calpers:
