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Case Study: Volatility Control Equities
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Case Study: Volatility Control Equities


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  • 1. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 Case Study: Volatility Controlled Equities August 2013 1
  • 2. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 Situation: A mature, underfunded pension scheme with a weak sponsor covenant • A c£3.5bn closed pension scheme with a deficit of c£300m on self sufficiency basis and a weak sponsor covenant • Mature scheme with annual pension payments of c5% of its assets Investment Strategy • Primary source of return to fund the Scheme’s deficit in the absence of sponsor contributions • Highly path dependent and vulnerable to stress events which can throw the Scheme off course its flight path • Operates on a very tight risk budget with a well defined Pension Risk Management Framework (PRMF) driving the Scheme’s asset allocation Governance Framework • Quarterly Board Trustee Meeting responsible for setting overall risk and return parameters for the Scheme • A sophisticated ISC which meets at least 8 times a year or more if required • An in-house team led by a CIO for management and implementation of investment strategy 2
  • 3. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 Task: Reduce downside risk while maintaining expected returns • Adopting an equity benchmark which controls the amount of risk the Scheme is exposed to fits well with the Scheme’s objectives and constraints by allowing it to capture growth while providing protection from severe market events, which might affect the Scheme’s Flight Plan • In a volatility controlled equity index, the Scheme’s exposure to equities is dynamically managed to achieve a target volatility level. • By varying exposure in response to market conditions, volatility controlled equity indices have historically limited drawdowns and delivered equity-like returns with substantially lower volatility (see Appendix I) • A further advantage of using an equity index that carefully controls the level of risk is that it cheapens the cost of buying explicit downside protection via a “put option. For example, to protect a global equity portfolio against a fall in value of more than 10%, over a one year period would cost between 3 - 4%(depending on market conditions). The same protection for a global, volatility-controlled index costs less than 1% 3 Left: Volatility-controlled equity index allocation As equity volatility rises (red line), exposure to equities (black line) is reduced towards cash (and vice versa) to keep the volatility at the target level.
  • 4. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 Action: Implementation of the first volatility controlled equity structure 4 April 2013 Redington presents the principles underlying volatility control as part of an overall strategic review of the Scheme to the Investment Committee(IC) June 2013 A follow up detailed presentation to the IC covering: • Historical performance • Potential structures available for investment • Cost of implementation (including indicative pricing for put option) • Impact of replacing Scheme’s equity exposure by volatility controlled equities + Put on risk and return profile July 2013 Training for the full Trustee Board on the structureIC agrees allocation subject to Board approval Redington starts preliminary discussions with the LDI manager re: implementation Trustee Board approval Aug 2013 1st volatility controlled equity with put structure implemented (see Appendix II) Close discussions with the LDI manager and one conference call with the IC to finalise: • Underlying index for equities • Management of currency hedging • Term sheet and formulae for calculating volatility • Dealing dates to avoid being out of market Timeline Redington works with banks and fund managers to establish feasibility of idea
  • 5. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 Result: A better risk adjusted return profile for the Scheme • The Scheme changed its approach to managing equities and adopted a volatility controlled index as its benchmark with a put option at 90% strike on the index. • As a result, the Scheme: o Manages its equity exposure in a risk controlled way through a target volatility of 10% o Reduced its equity risk by two thirds i.e. from c30% to 10% of notional equity exposure o Decreased downside risk by buying explicit protection at affordable levels while still maintaining its path to full funding o Diversified its portfolio further between different risk factors such as credit, illiquidity, insurance risks 5 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 0% 5% 10% 15% 20% 25% 30% ExpectedReturnoverswaps(bps) VaR95 (% of notional exposure) Starting Point Stages Description Starting Point 100% allocation in equities Stage 1 100% allocation in volatility control equities Stage 2 Add a put option to the volatility control equities Stage 1 Stage 2 Risk-Return Illustration of Scheme’s equity portfolio
  • 6. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 Appendix I: Historical Performance 6 0 40 80 120 160 200 May-01 May-02 May-03 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 Passive Equity Vol Controlled Equity Vol Controlled Equity with Put 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTD Passive Equity -17.26% 38.04% 16.54% 12.92% 17.77% 11.36% -46.47% 41.97% 13.63% -9.60% 16.07% 7.30% Vol-Controlled equity -11.59% 31.92% 21.94% 14.53% 21.78% 5.74% -26.79% 17.11% 7.58% -6.42% 7.81% 7.01% Vol-controlled Equity with Put Option -11.93% 31.28% 21.35% 13.99% 21.19% 5.26% -17.92% 16.53% 7.09% -6.84% 7.29% 6.54% -60.00% -40.00% -20.00% 0.00% 20.00% 40.00% 60.00% Passive Equity Vol-Controlled equity Vol-controlled Equity with Put Option Source: Redington, Bloomberg The chart and table below compares the historical performance of a 70% MSCI developed world, 30% EM index (“70:30 index”), 10% volatility controlled 70:30 index and 10% volatility controlled 70:30 index with 85% put.
  • 7. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 Appendix II: Implementation Structure 7 Case Study Pension Scheme Bank 3m Libor + X Volatility controlled index with a 1y put option at 90% on the index Key Terms of 1y Total Return Swap Client pays 3m USD Libor + X Client receives Return on [Index] – 3m LIBOR + Put option at [Strike] on the [Index] Index 10% volatility controlled equity index (70% MSCI World Net of Dividend Tax + 30% MSCI Emerging Markets Index Net of Dividend Tax) Strike for Put Option 90% Volatility Measure Maximum of exponentially Weighted Moving Average with = 3% and 6%
  • 8. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 Contacts 8 Disclaimer text For professional investors only. Not suitable for private customers. The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed transactions should be treated as preliminary and subject to further due diligence . Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees' actuarial advisors. Redington Ltd will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in that estimation. Additionally, the client recognizes that Redington Ltd does not owe any party a duty of care in this respect. Redington Ltd are investment consultants regulated by the Financial Conduct Authority. We do not advise on all implications of the transactions described herein. This information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate. ©Redington Limited 2013. All rights reserved. No reproduction, copy, transmission or translation in whole or in part of this presentation may be made without permission. Application for permission should be made to Redington Limited at the address below. Redington Limited (6660006) is registered in England and Wales. Registered office: 13-15 Mallow Street London EC1Y 8RD Robert Gardner Co-Founder & Co-CEO Direct Line: 020 7250 3416 Dan Mikulskis Co-Head of ALM & Investment Strategy Direct Line: 020 3326 7129 Neha Bhargava Senior Vice President | Investment Consulting Direct Line: 020 3326 7156