Case study vol control equities 1 page


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Case study vol control equities 1 page

  1. 1. Private & Confidential Case Study: Volatility Control Equities 19 August 2013 Case Study: Adopting a risk controlled approach to managing equity allocation Situation: • 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. Task: • 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%). Action: • 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. 1 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 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 by reducing relative equity risk. Result: