The Dangerous Game Playing Out in Portfolios

Pension funds’ relentless yield-chasing sets them up to be forced sellers at the next downturn,warnsquant shop Intech.

Illustration by II

Illustration by II

Many pension funds — having loaded up on private equity and other illiquid assets — will have only one option in the next crash, according to a quant firm: sell their stocks.

While researching for clients, Janus Henderson’s $50 billion quantitative manager Intech concluded that pension plans have had to take triple the risk as they did 20 years ago for a 7.5 percent return. During that time period, interest rates have dramatically declined, pushing many plans to compensate with private equity and higher-yielding, but less-liquid, credit. Over time these asset classes can boost returns, but they can’t be readily bought and sold.

“Plans have allocated away from traditional fixed income and equities into hedge funds, infrastructure, private debt, emerging markets debt, agriculture, and real estate,” said James McHugh, Intech’s senior managing director for investment solutions, in an interview. “These things tend to be less liquid. The unintended consequence of that shift is that equites have become the liquidity source to raise money.”

That has little downside in a bull market. “But if the market does experience distress, plans may be forced to sell into a market downturn, compounding the problem,” McHugh pointed out.

It’s happened before. Institutions sold off stocks in 2008 and 2009 to raise cash as their hedge funds gated redemptions and private equity firms continued to call capital through worst of the market rout. But ten years later, McHugh said, the fallout could be worse. The average institution now has more allocated to illiquid assets than it did heading into the last crisis.

[II Deep Dive: Giant Allocators Love Illiquid Investments. Are They Ignoring Risk?]


Intech believes that plans’ shift from active to passive strategies has exacerbated the problem. Index-tracking funds rise and fall alongside the market, with no active managers trying to protect the downside.

“The risks associated with the impact of a downturn seem to be increasing the longer we go,” McHugh said, referring to the nine-year bull market. “We’re thinking about ways to reduce the risk of that beta exposure,” based on numerous conversations with clients.

According to the research report, “instead of turning their backs on public equities, pension plans can dial back their market-risk exposure by rethinking the impact beta risk has on their overall portfolios. Perhaps plans should consider adjusting their asset allocations to include lower beta equity exposure as a permanent commitment.”

Intech believes that numerous equity strategies exist that offer lower exposure to beta — the overall market — and thus would provide a bit of a hedge in a downturn. Another option is to dynamically shift a portfolio’s beta to match the risks signaled by the equity market over time.

“Some have called this ‘variable beta’,” the report stated. “By adjusting allocations, plan sponsors can reach a better balance between raising cash to fund immediate payouts while generating the returns they need to sustain their plans in the future.”