Private & Confidential Case Study: Volatility Control Equities 19 August 2013
Case Study: Adopting a risk controlled approach to managing equity allocation
• A c£3.5bn closed and mature pension scheme with weak sponsor covenant, facing
a deficit of c£300m on a self sufficiency basis.
• The Scheme relies primarily on returns from investment strategy to fund its deficit in
the absence of significant sponsor contributions.
• The Scheme is therefore highly path dependent and vulnerable to stress events
which could throw it off course from its flight path.
• To reduce downside risk from equities while maintaining returns required for the
Scheme’s path to full funding.
• Redington recommended for the Scheme to adopt a risk controlled approach to
managing its equity allocation. Under this approach, the Scheme’s equity exposure
is dynamically managed to achieve a target volatility level.
- For example as equity volatility rises, exposure to equities is reduced
towards cash to keep the volatility at the target level
- Historical analysis showed that, across equity markets and time
periods, adopting this approach enables the Scheme to limit draw-downs and
deliver equity-like returns with substantially lower volatility
• A further advantage of managing equity against a target volatility is that it cheapens
the cost of buying explicit downside protection via a “put option” .
- For example, the cost to protect a global equity portfolio against a fall in
value of more than 10% over a one-year period may cost between 3-
4%, however, the same protection for a global, volatility controlled index
costs less than 1%).
• Following Trustee Training and Board Approval, the Trustees moved the equity
benchmark to a volatility controlled index with a target volatility of 10% and bought a
put option at a strike of 90% on the index.
• Redington also advised on other key parameters of the structure including
implementation vehicle, underlying index and management of currency hedging.
• The structure was executed by the Scheme’s LDI manager with oversight by
Redington as a total return swap with an investment bank.
0% 5% 10% 15% 20% 25% 30%
VaR95 (% of notional exposure)
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
Risk-Return Illustration of Scheme’s Equity Portfolio
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
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 by reducing relative equity risk.