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LDI Alert

Time to rethink your return-seeking allocation?

Amy Trainor, FSA, Multi-Asset Strategist
2023-09-30
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Surveying the current market environment, we see a case for reviewing a corporate defined benefit (DB) plan’s return-seeking strategy and considering structural allocations to defensive equities and diversifiers.

A cornerstone of our investment approach

We believe that a diversified return-seeking portfolio should complement core equities with:

  • Defensive equity strategies that aim to outperform in down equity markets while preserving opportunities for funded-ratio growth. Examples include income-oriented equities, “cash compounder” approaches that invest in companies with high and stable free-cash-flow yields, and low-volatility approaches.
  • Diversifiers that seek to provide more explicit downside mitigation in equity sell-offs, such as real estate, infrastructure, net long hedge funds, and return-seeking fixed income.

A plan employing a hypothetical portfolio with equal allocations to core equities, defensive equities, and diversifiers would have ended the 1995 – 2021 period with a funded ratio more than 10% higher than a plan investing its return-seeking portfolio solely in core equities (Figure 1). Why? Better downside mitigation: The diversified portfolio would have captured just 81% of the equity market downside during this period. This was especially valuable in the extreme bear markets of the early 2000s and the global financial crisis, but it also enabled the funded ratio to largely keep pace in up markets, as even in a bull market, equities do not rise consistently upward. In fact, this outperformance occurred despite the diversified portfolio capturing just 85% of the upside in the global equity index over this time period.

Figure 1
time-to-re-think-your-return-seeking-allocation-fig1

Why now?

We see several reasons to consider a more diversified return-seeking portfolio:

  • Seek to protect funded-status gains. On average, funded ratios are up more than 10% since year-end 2020.1 Diversifying the return-seeking allocation can potentially help preserve any funded-ratio gains, either as a complement to — or substitute for — traditional derisking from equities to liability-hedging fixed income. A smaller return-seeking weight may also provide the impetus to evaluate how to increase effectiveness/efficiency and to consolidate approaches (e.g., by implementing global mandates rather than discrete US and non-US investments).
  • Potential for higher asset volatility and risk premia. Our macro team believes that central banks will face a stark trade-off between supporting growth and controlling inflation, based on the team’s view that secular forces such as globalization and aging demographics will result in structurally higher and more volatile inflation. This environment stands in contrast to the last roughly two decades, when low inflationary pressures allowed central banks to inject liquidity, which supported risk assets, at any sign of an economic downturn. The consequence, as our colleagues discussed in a recent article, may be a return to more frequent and volatile economic cycles, accompanied by higher asset volatility and higher asset risk premia.

    Despite the year-to-date equity sell-off, we think the potential for higher asset volatility amid more frequent cycles and the wide range of possible economic outcomes (including the risk that central banks fail to tame inflation, or tighten their economies into recession) make this a prudent time to consider incorporating more defensiveness and diversification into a return-seeking strategy. Our Fundamental Factor Team believes that high-quality stocks, including those with high and stable profitability and low solvency risk, are priced attractively relative to their fundamentals and currently exhibit below-average momentum (unusual in a sell-off), suggesting that it is potentially not too late to initiate or add to these types of stocks.  Finally, the narrowness of the stock market over the last five years, with megacap stocks driving a historically high share of equity market returns, may further support the case for examining portfolio diversification (read more on this topic here).
  • Infrastructure’s appeal. One diversifier that we think is particularly interesting in a higher inflation environment is listed infrastructure, as companies that own long-lived assets can often pass through higher costs, either explicitly or implicitly. The historically steady nature of returns on long-lived assets, which are often set and protected by regulation or contract, may also make this asset class appealing — given their potential for lower volatility and the ability to outperform broad equities in downturns. Read more from our colleagues here.

The risk to our view is that is that if we return to the previous environment of low inflation and central bank support, a return-seeking allocation focused on core equities could potentially outperform a more diversified return-seeking allocation. As noted, however, this is not our base case, and given the improved funded status of many plans, we think protecting funded-ratio gains and being prepared for a potential range of outcomes by diversifying the return-seeking allocation is worth considering.

1Current funded ratio estimate as of 26 August 2022. Funded ratios and discount rates estimated by Wellington Management based on change in yields of high-quality corporate bonds (Bloomberg Barclays US Long Credit Aa) since 31 December 2021 and performance of equities (MSCI World), bonds (Bloomberg Barclays US Long Gov/Credit, Bloomberg Barclays US Aggregate), hedge funds (HFRI Fund Weighted Composite Index), and real estate (NCREIF Property Index). Actual results may differ significantly from estimates. Results are presented at the aggregate Russell 3000 Index level. Data is that of a third party. While data is believed to be reliable, no assurance is being provided as to its accuracy or completeness. Sources: FactSet, Wellington Management.

Important disclosures

Views expressed are those of the authors, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities. Please consult your own third-party advisers and actuaries before making any investment decisions based on this information.

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