How Allocators are Weatherproofing Their Portfolios

In hindsight, Peter Madsen wishes his team had advised clients to include managed futures in their portfolios. These funds, which generally employ trend-following strategies to trade derivatives tied to a wide range of markets including commodities and currencies, performed extraordinarily well during the global financial crisis of 2008. That year, managed-futures funds returned 14 percent, while the Standard & Poor’s 500 index fell about 37 percent and the average hedge fund lost nearly 20 percent. For investors who always carry an umbrella because they don’t know exactly when it will rain, managed-futures funds proved to be a savvy bet.

Madsen, then an investment consultant and now the chief investment officer of the Utah School & Institutional Trust Funds Office (SITFO), says he’s now implementing a downside protection strategy on SITFO’s $2 billion portfolio that includes managed futures — sometimes known as commodity trading advisers, or CTAs. “I learned a lot from the crisis, and since then I’ve gotten more comfortable with CTAs and similar strategies,” he says. SITFO was established from scratch two years ago to professionally manage an existing portfolio that is used for education in the state and that had previously been overseen by another government agency.

SITFO is among a growing number of institutional investors, including the State of Hawaii Employees’ Retirement System, that are getting defensive in the face of a long-running bull market in stocks, bonds, and other assets. With yields at historic lows and interest rates on the rise, pensions and other institutions are looking to dial up their use of other diversification strategies, often by creating a subportfolio of CTAs, alternative risk premia strategies (mimicking hedge fund returns), and long-duration Treasuries to create a so-called offset when equity markets get rocky.

Man FRM, a division of U.K.–based fund management conglomerate Man Group, is providing SITFO with an actively managed portfolio comprising both internal and external investment managers through its managed-account program. Institutional investors have been increasingly interested in defensive strategies for about a year, says Michelle McCloskey, president of Man Americas and Man FRM. “Investors have had a long run of good performance in equity markets, but we feel markets are at a point of extended valuations,” she says. “Given elections around the world, and events like Brexit, investors are asking what they need to do to be prepared and how they get to an appropriate level of diversification.”

Hawaii’s retirement system worked with the Pension Consulting Alliance to implement what it calls a “crisis risk offset” program. Man FRM was hired to implement it and carry out risk oversight and rebalancing through its managed-account platform. Vijoy Chattergy, chief investment officer of the state’s retirement system, says Hawaii uses a mix of long-duration Treasuries to take the first blow in a crisis, when there is a flight to quality. If the crisis is sustained, the systematic trend-following strategies will kick in. The alternative risk premia strategy produces positive performance over the long run, although returns may not be positive in a crisis situation. “Sometimes people confuse this with hedging; this is an offset,” he says. “If our portfolio has a drawdown less than the market, then we’ll consider this successful.”

Utah’s Madsen says he established an allocation in SITFO’s portfolio specifically to play defense. “It’s anti-risk,” he says. SITFO is using a mix that contains, among others, alternative beta investments and trend-following CTAs, including strategies from Man AHL. Man can customize programs for investors that simplify reporting and operations and mix internal and external managers for pensions, endowments, and other institutions.

“Investors are doing a lot of work on managed futures, which performed quite well in ’08,” says McCloskey. “These strategies could move relatively quickly if markets start to go into an extended downturn and may act as a counterpoint to assets that are taking a hit.”

Other managers are getting creative as well. Milliman Financial Risk Management, an institutional risk management firm, will subadvise exchange-traded funds for insurance company and asset manager Transamerica Corp. Transamerica’s DeltaShares series has incorporated Milliman’s institutional risk management into rules-based passive funds. The planned ETFs, which aim to stabilize volatility and manage the downside risk of equities during long declines in markets and periods of heightened volatility, will include U.S. large-cap, mid-cap, and small-cap funds; international developed-markets funds; and emerging-markets funds. Some may hope that by owning DeltaShares, the first ETFs to offer crisis-protection strategies, they can stave off the next bout of rain.