Local Government Pension Scheme funds can implement a cost-effective equity protection strategy that provides protection if equities fall.
Importantly, LGPS funds with equity protection strategies can continue to retain their exposure to future equity market gains, which are necessary for the ongoing funding of benefits.
Considering an equity protection strategy
Equities have had a strong run recently and have contributed to the recent improvement in funding levels being enjoyed by many LGPS funds. It is also notable that in 2017 the VIX (a measure of equity market volatility) reached its lowest closing level since 1993. Understandably, investors have become increasingly concerned that this may be the calm before the storm.
These investors, the LGPS among them, may be pleased to hear that lower volatility cheapens the cost of buying protection. With the average fund currently allocating 60% of assets to equities (Figure 1), LGPS funds have a high dependency on equity returns and can hence be significantly impacted by a downturn in equities.
However, many LGPS funds do not want to significantly reduce their equity weights any time soon as they require future equity-like returns to support funding levels. This is why a number of LGPS funds are considering equity protection instead as a tool to help improve their investment outcomes and achieve their long-term investment objectives.
At LGIM, we have been engaging with a number of clients to explore solutions that help to protect against future equity market falls. This includes the implementation of strategies that can be executed quickly and cost-effectively, with limited governance.
What protection can the strategy provide?
Figure 2 shows the return of an example equity protection strategy under a range of scenarios. For comparison, we have also shown the return that might be achieved by investing in equity markets without protection. In this example, protection is purchased against a fall in equity markets of between 5% and 25%, without giving up most of the potential for future equity gains. The strategy gives partial protection for equity falls of more than 25%.
What are the implementation considerations?
Pragmatism: For many LGPS funds, pragmatism will be key. Implementation of an equity protection strategy is therefore likely to be via a pooled vehicle bespoke to their Fund. This yields the significant benefit of implementing a bespoke strategy while also seeking to minimise the governance burden faced by LGPS funds and their committees.
Costs: For the derivatives underlying the protection, committees are likely to favour the most liquid and cost-effective instruments
Regulation: All regulatory matters concerning the operation of the mandate would be managed by the manager.
Funding protection: If LGPS funds identify a level of equity market return required to meet their long-term funding objectives, and above which they are happy not to participate, then they can sell exposure to those excess returns and use the money raised to finance the purchase of protection (full or partial).
In a world fraught with uncertainty, considering now how these strategies could be adopted in future will mean LGPS funds can respond quickly to time-sensitive opportunities.
James Sparshott, head of local authorities, Legal & General Investment Management, 44 (0) 203 124 3135, firstname.lastname@example.org
Column sponsored and supplied by LGIM
Derivatives may have greater volatility than the securities or markets they relate to. A change in value of a derivative may not correlate to a change in value of the underlying instruments. This may result in losses greater than the direct investment in those securities or markets.
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