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Improving coverage ratios with less risk

29-10-2010 | Research | Pim van Vliet, PhD Pension funds can protect funding ratios by making low-risk stocks a part of their equity allocation, says Pim van Vliet, Senior Portfolio Manager, Robeco Low Volatility Equities.

Pension funds around the world are facing funding risks. In the “new normal” environment of low interest rates, slower economic growth and more volatile markets, many pension funds are rethinking their allocations. Some are increasing exposure to equities to add returns, while others are reducing their allocations to risky assets to ensure funding levels are not further eroded.

Pim van Vliet, however, has another idea. “Pension funds should shift a portion of their global equity allocation to low-risk stocks,” he says. This suggestion is based on his research that low-beta and low-volatility stocks can improve risk-adjusted returns and preserve funding ratios in down markets.

Higher risk does not mean higher returns
For the past 30 years, evidence has been accumulating about the relationship between risk and return. This research calls into question the capital asset pricing model (CAPM), which is a commonly accepted theory that an asset’s required rate of return can be calculated based on its risk, with higher-risk stocks expected to produce better returns than lower-risk stocks.

Low-beta stocks have higher returns
Finance heavyweights Fischer Black, Myron Scholes and Eugene Fama were among the first to document that US stocks with low xbetas had higher returns than could be expected from CAPM. Beta is the tendency of a stock’s return to respond to market swings. A lower beta signals lower risk.

Low volatility leads to better risk-adjusted returns
Research by Van Vliet and David Blitz at Robeco not only confirmed that the low-beta effect also existed in non-US markets, but went one step further. “We also documented a related volatility effect,” says Van Vliet. “We found that low-volatility stocks have better risk-adjusted returns than high-volatility stocks in the long-term.”

Volatility is the amount of uncertainty around changes in a security’s value over time, with high volatility indicating higher risk. Their award-winning research, “The Volatility Effect: Lower Risk without Lower Return,” was published in 2007 in the Journal of Portfolio Management.

Conservative Equity: a low-risk strategy with alpha factors
By then, Robeco had already introduced the Conservative Equity strategy, which exploits both the low-beta and low-volatility effects to capture the better risk/return profile of low-risk stocks. The stock selection model of the purely rules-based strategy also includes additional alpha factors.

“By replacing a portion of a global equity allocation with a low-risk strategy, such as Conservative Equity,” says Van Vliet, “pension funds can realize the equity premium that enables them to pay future liabilities, stabilize funding ratios and reduce overall portfolio risk.”

Low-risk strategy positive for funding ratios
The benefits of a low-risk strategy for pension funds are evident in the graph below. It compares the funding ratio development of two pension fund portfolios, equally divided into liability-matching bonds and equity investments. The test period begins with the start date of the Conservative Equity strategy in October 2006 and continues through December 2011.
One portfolio consists 50% of liability-matched bonds and 50% global equities invested in the MSCI World Index. The second portfolio has the same fixed-income allocation, but the MSCI World equities portion is replaced with the global Robeco Conservative Equities strategy.

Effect of the Conservative Equity strategy on pension fund funding ratios
Funding ratio development of typical Dutch pension fund
improving-coverage-ratios-with-less-risk.jpg
Source: Robeco Quantitative Strategies
The funding ratio of the portfolio with the equity allocation to the MSCI World Index dipped below 100% during the financial crisis. Meanwhile, the portfolio with the allocation to Conservative Equity not only performed better during the crisis, but ended the period with a funding ratio well above that of the other portfolio.

“As shown in this example, by switching from global equities to a low-risk global equities strategy, a pension fund would have maintained a funding ratio of at least 105% throughout the turbulent market of 2008 to 2011,” points out Van Vliet. “The addition of Conservative Equity would have eliminated the need for any additional contributions from the plan’s sponsor or changes in the conditions of the pension plan.”

Investors overpay for high-risk stocks
According to Van Vliet, the Conservative Equity strategy’s better risk-adjusted returns are based on the willingness of investors to overpay for high-risk stocks.

He notes that low-risk stocks typically have higher tracking errors, which is an unfavorable characteristic for portfolio managers investing relative to a benchmark. Moreover, high-risk stocks typically do well in bull markets, when their outperformance attracts more attention from investors, leading to more demand and overvaluation. “The outperformance of higher risk stocks in up-markets becomes more of a draw to investors than the capacity of low-risk stocks to preserve equity capital in down-markets,” he says.

Capital preservation is key
Indeed, this may be the most powerful argument for the Conservative Equity strategy. By losing less during bear markets, a portfolio of low-beta and low-volatility stocks preserves equity capital. Such a portfolio is then better positioned when markets begin to rise, having to recoup fewer losses compared with “normal” equity portfolios. In moderate or rising markets, low-risk stocks move in line or even produce excess returns relative to the market. It is not all clear sailing, however, since low-risk stocks will likely lag the market during strong bull markets or bubbles.

“The benefits of a low-risk strategy are clear,” say Van Vliet. “Lower risk stocks still profit from the equity premium, but with less downside risk. This means more stable coverage ratios for pension funds.”

The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
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