With a rate-hiking cycle likely on the horizon, many investors are expecting a cyclical rise in bond yields. A fair question to ask is, Is the expected reward from waiting for higher yields worth the higher surplus risk from maintaining a duration mismatch relative to liabilities?
Given the level and volatility of yields, we would argue that, depending on risk tolerances and return requirements, the answer may well be no. The extra return earned from waiting for yields to rise has several components beyond just the relative gain.
• First, if the alternative to fixed-income exposure is to add return-seeking assets, then there is an opportunity gain from investing in strategies that seek better returns.
• Second, staying in cash or cash equivalents is likely to result in a compromise for yield, since in an upward-sloping yield curve environment, long-duration exposure will have a greater payoff.
• Third and finally, as yields rise, the returns from a short-duration position will depend on the magnitude of the increase in yields. Assuming a rate environment in which interest rates go up over time, the forward yield curve in the futures market will indicate the magnitude that yields must rise to offset the opportunity cost of the greater carry available.
If higher yields aren’t going to help close the funding gap, what else can a plan sponsor do? The answer, we at J.P. Morgan Asset Management believe, is to add risk assets. There are several practical ways that pension managers can try to improve funded status even in an environment of lower returns:
Allocate to hedge funds, private equity and real estate investments that have built-in leverage. Portfolio managers can allocate to strategies that have built-in leverage and that, presumably, should also increase expected return. Hedge funds typically use leverage in many ways. As the name suggests, long-short equity hedge funds, the most prevalent, use a combination of long and short positions, often with gross exposures in excess of 100 percent, to achieve their returns. Private equity sponsors use leverage in structuring a majority of the deals for buyout funds, the most important category of private equity. Real estate funds typically also use modest amounts of leverage to increase returns.
Consider direct allocation investments with illiquid assets. Investors who are willing to tie up their money for years should expect to receive an illiquidity premium, another possible source of expected return in a return-starved world.
Keep your eyes open for the right moment. Investors who are willing to provide liquidity at times when there is little to none might also harvest a fat illiquidity premium. But a better description of such an approach might be opportunistic investing. In the depths of the 2008–’09 financial crisis, all but the most liquid asset classes were offering outsize liquidity premiums. In periods of market dislocation — which come along with some regularity — there are often chances for nimble investors to accumulate assets that will generate excess returns.
Invest with active managers. The rise of passive investing should really be a boon for those investors looking to alpha as a way to generate additional return. Wall Street firms cut back their research budgets during the global financial crisis. As a result, analysts now cover fewer investment opportunities in less depth. At the same time, large flows to indexers, relative to active managers, suggest that there may be relatively less money chasing those better-hidden opportunities. Managers of scale that invest in active research may therefore have opportunities to generate more alpha going forward.
Increase exposure to systematic market, or beta, risks. Returns have traditionally been viewed as consisting of both an alpha and a beta component. In general terms, beta is the return investors earn for being exposed to the risks of the overall market, generally represented by a cap-weighted index. Alpha is the additional return a manager generates over a benchmark index through skilled investing. Recently, this distinction between alpha and beta has become blurred by the identification of hedge fund strategy–related risk components that can be captured through passive, rules-based investing. Alternative beta strategies represent that rules-based approach and can provide investors with an additional, more cost-efficient way to gain exposure to some of the systematic risks associated with a variety of hedge fund styles.
Add tactical overlay. This style, known as global tactical asset allocation, uses a wide range of systematic betas. The collection of betas can be added on top of an existing asset allocation, resulting in more leverage.
A combination of these strategies, used at different times and under different circumstances, can help pension investors achieve their return targets in a low-return environment.
Tony Gould is the global head of pension solutions and advisory at J.P. Morgan Asset Management in New York.
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