The importance of diversification
De-risking is tricky for the LGPS in current markets. As we’ve argued previously, low expected returns from high quality bonds means that many schemes will need to retain exposure to risk assets to generate the long-term returns that they require. However, with the Covid-19 crisis causing equity volatility to spike, the recent rollercoaster ride on global markets will have served as a timely reminder to investors of the merits of diversification.
Look beyond traditional bonds
Diversification will be key as the LGPS looks to rebuild funding levels in the wake of the Covid-19 crisis. Equity exposure remains crucial to meet long-term funding targets, but with bond yields so low, schemes must look to a wider range of asset classes to effectively diversify equity risk—including allocations to public and private credit, hedge funds and real assets.
To illustrate the opportunities to diversify beyond traditional government bonds, we consider the potential benefit for the average LGPS of adding a 5% allocation to a range of high level asset class categories:
- Gilts – broad exposure to UK government bonds.
- Core credit – global aggregate investment grade credit..
- High yield – split equally across US high yield, European high yield and US leveraged loans.
- Emerging market debt – split equally across hard currency sovereign, hard currency corporate and local currency sovereign debt.
- Equities – between developed and emerging markets in line with market cap, and with developed equity hedged back to GBP.
- Real assets – split 60%/40% between global real estate and global infrastructure. For real estate the regional split is 50% US, 30% Europe and 20% Asia Pacific. US dollar exposure is hedged back to GBP.
- Hedge funds – split equally across the five categories for which we maintain long-term capital markets assumptions.
In order to fund each new 5% allocation, we sell a pro-rata slice of the average LGPS’s existing assets. We then measure the benefit as the improvement (or otherwise) in the Sharpe ratio—an asset-liability measure of portfolio efficiency.
Impact on average LGPS portfolio efficiency for 5% allocation to various asset classes
Consider a wide range of assets
We find that adding more exposure to Gilts is inefficient for the LGPS. Instead, adding exposure to high quality credit appears to be the better option, helping to reduce volatility without sacrificing as much expected return as would be the case with an additional allocation to government bonds.
Adding extended credit (high yield or emerging market debt) and real assets also enhances efficiency by lowering volatility while preserving levels of expected return. The fact that emerging market debt reduces risk is perhaps not surprising given much of the asset class is investment-grade quality, particularly in the corporate portion of the market that has held up well through the crisis, potentially hastening its emergence as core credit.
High yield also offers the LGPS long-term return potential, while we generally expect that dislocation-driven opportunities will become visible most quickly in this segment. Core real assets, on the other hand, continue to offer stable, income-driven returns that offer strong diversification to both equities and bonds.
Adding equity exposure does, of course, add risk, but based on market conditions at the end of March, the additional risk was expected to be well rewarded. Some of this potential upside has been eroded by the recent rally, but these results highlight the importance of regular portfolio rebalancing and the benefits of “buying on the dips” should we experience further volatility in listed equity markets.
Hedge funds are marginal in this analysis, but our return expectations are based on the median manager. Hedge fund returns are of course widely dispersed across managers, and in general the median manager return is not sufficient to reward investors for the idiosyncratic risks that they take on when investing. For those investors who have confidence that they can select above-median managers and secure a higher-than-median return, the potential improvement in efficiency will be greater than our research suggests.
Capitalise on new cycle opportunities
The Covid-19 crisis marked the end of the previous market cycle. While the current market backdrop is challenging, the beginning of a new cycle brings with it many new investment opportunities. Risk premia are elevated across a range of risk assets, presenting attractive long-term options for the average LGPS to reinforce and enhance portfolio diversification—and to mitigate equity risk.
If you would like to discuss the points raised above in more detail, please don’t hesitate to contact your usual J.P. Morgan Asset Management representative.
Diversification does not guarantee positive returns and does not eliminate the risk of loss. Forecast is not a reliable indicator of future performance.