As pension plans continue to reduce their risk, it is critical that plan managers take a holistic approach to portfolio analysis. Creating discrete allocations to so-called gredge assets — those having characteristics of both growth and hedging assets — that fail to account for this blend of features can create artificial constraints. Separating assets into hedging and growth simplifies pension management but with the cost of suboptimal portfolio outcomes.
At J.P. Morgan Asset Management, we modeled a wide range of pension portfolio scenarios, changing funded status, return targets and hedge and growth allocations. We then examined the surplus volatility of six different allocations: one holistically constructed portfolio and five other bucketed portfolios that optimized hedge and growth investments separately without accounting for gredge factors. The portfolios in question consist of 40 percent hedge assets and 60 percent growth assets and differ only in how they apportion allocations within either category, which will affect funded status volatility. We constrained the models still further to conform to real-world investment limitations and held allocations to alternative assets — private equity, real estate and hedge funds — to no more than 5 percent each and the total allocation to extended credit to 15 percent in all six portfolios.
The gredge-aware holistic portfolio reduced annual funded status volatility by 20 basis points on average. The Treasuries in the liability-hedging bucket have correlation tendencies that enable them to perform a dual role. In addition to correlating strongly to plan liabilities, they tend to correlate negatively to the equities in the plan’s growth bucket. By tilting toward Treasuries in its hedge portfolio, a plan can dial up the potential in its growth portfolio without compromising its hedge ratio or adding surplus volatility. That way, the model can allocate more to high-volatility, high-return assets and achieve the standard 7 percent growth target while reducing volatility overall.
In contrast, separate growth and hedge portfolio optimizations lead to an overallocation to U.S. long credit and an underallocation to U.S. long Treasuries, in large part because the portfolios do not seek to mitigate the economic risk embedded in return-seeking assets — a key benefit of gredge assets. The growth buckets also suffer from biases in the five bucketed portfolios: As those buckets hold fewer Treasuries to hedge economic risk, they are underinvested in public and private equities and, as a result, are overinvested in real estate and hedge funds.
The sharpest distinction between the holistic and the bucketed portfolios lies in their hedge allocations. Whereas the holistic portfolio is more or less evenly balanced between U.S. long credit and Treasuries, the bucketed portfolios have a minimal allocation to Treasuries. Their credit overweight compels them to trim their economic risk exposure and, as noted, their return potential. They average an 8 percent lower allocation to equities than the holistic portfolio, compensated for by a 5 percent greater allocation to real estate, plus 3 percent more to hedge funds. These are not radical portfolio adjustments, but they do underscore the fact that a bucketed approach generates less efficient portfolios.
A major part of the efficiency gained by the holistic approach derives from its ability to meet the 7 percent return target while investing in U.S. Treasuries, which are modeled as lower-return and higher-duration assets than U.S. long credit. The proxies we used to model the two fixed-income assets showed a consistent difference in duration over time. Since the holistic portfolio allocates more to Treasuries, its duration is 0.75 years longer than the average of the five bucketed portfolios.
In examining Treasuries’ role in enhancing the holistic portfolio’s efficiency, we do not mean to underestimate the utility and value of extended credit. We found that the allocation to high-yield and emerging-markets debt maxed out at the 15 percent constraint under both construction methodologies. The result is especially noteworthy because many plans do not use extended credit to its full capacity.
This observation is both ironic and represents a missed opportunity, for extended credit is the quintessential gredge asset: It adds portfolio duration and offers a potential rate of return in excess of liability growth. Extended credit is an asset class that today’s pension plans should get to know and consider adding strategically to holistic portfolios.
Tony Gould is the global head of pension solutions and advisory at J.P. Morgan Asset Management in New York.
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