Illustration by II
Despite the longest economic expansion in U.S. history, the gap between the present value of liabilities and assets at U.S. state pensions is measured in trillions of dollars. To make matters worse, pensions are now faced with the reality that standard diversification — including extremely low-yielding bonds — may no longer serve as an effective hedge for equity risk.
While I was at CalPERS, concerns arose in 2016 about the effectiveness of standard portfolio diversification as prescribed by Modern Portfolio Theory. We began to recognize that management of portfolio risk and equity tail risk, in particular, was the key driver of long-term compound returns. Subsequently, we began to explore alternatives to standard diversification, including tail-risk hedging. At present, the need to rethink basic portfolio construction and risk mitigation is even greater — as rising hope in Modern Monetary Theory to support financial markets is possibly misplaced.
At the most recent peak in the U.S. equity market in February 2020, the average funded ratio for state pension funds was only 72 percent (ranging from 33 percent to 108 percent). That status undoubtedly has worsened with the recent turmoil in financial markets due to the global pandemic. How much further will it decline and to what extent pension contributions must be raised — at the worst possible time — remains to be seen if the economy is thrown into a prolonged recession.
A considerable body of evidence shows these funding problems are connected with how most pension portfolios have been constructed for more than a decade. Without changing the approach, it seems unlikely that funded status can be improved in the coming decade through investment performance alone.
I focus on a typical passive benchmark consisting of a 60 percent allocation to the Standard & Poor’s 500 Index and a 40 percent allocation to the Bloomberg Barclays US Aggregate Bond Index to illustrate the shortcomings of standard diversification since the global financial crisis of 2008 (GFC). Public pensions funds have steadily increased the allocation to alternative assets including private equity and real estate — reaching at present an average allocation of 28 percent to these investments. This overdiversification has only made matters worse. A recent paper by Richard Ennis shows that 46 public pension funds have underperformed a passive benchmark by about 1 percent per year in the period from July 2009 to June 2018. CalPERS, the largest U.S. pension, ranks near the bottom, underperforming by 2.36 percent.
The traditional 60/40 mix of stocks and bonds, commonly portrayed as an optimal portfolio, is supposed to mitigate the effects of this sort of extreme market volatility and deliver returns that pension fund managers can rely on. But the 60/40 mix is an artifact from another time. The optimal mix presumes it is possible to achieve a high rate of return while simultaneously constraining volatility. In practice, it limits portfolio volatility in benign market environments over the short term while making huge sacrifices in long-run performance. The so-called optimal portfolio is, in effect, the worst of all worlds. It offers scant protection against tail risk and, at the same time, achieves an under-allocation to riskier assets with higher returns in long periods of economic expansion, such as the past decade.
A basic way to see this is to compare performance of a 60/40 portfolio and the contribution from bonds over the full period from January 2008 to December 2019, which includes the GFC drawdown, and the recovery period from April 2009 to December 2019. The table below shows returns for the S&P 500, the Bloomberg Barclays US Aggregate Bond Index, and a 60/40 mix rebalanced monthly.
Even over the full period spanning the GFC, the large allocation to bonds still failed to provide enough protection to add value over the cycle — reducing the CAGR by 170 basis points. Astonishingly, this occurred in spite of concurrent bull-market rallies in bonds and equities during the recovery. Pension funds adopting the standard diversified portfolio failed to achieve a sufficient rate of return to improve funded status meaningfully.
There are valid reasons to hold some allocation to bonds. Maintenance of liquidity is one. However, investors must seriously consider the limited diversification and risk mitigation benefits — and explore other avenues. Direct tail-risk hedging using equity put options has proven a successful approach. Tail-risk hedging provides protection against extreme market moves that have occurred historically at a frequency well beyond what is predicted by a normal return distribution.
Properly managed options-based tail-risk hedging can raise the CAGR where bonds have failed. Over time this can improve funded ratios, regardless of interim market crashes. Standard risk mitigation through diversification in the pursuit of higher Sharpe ratio has almost uniformly lowered the CAGR of a typical pension over a full market cycle.
To be clear, there is no free lunch, as the ideal options strategies trade small losses over extended periods when equities are rising for extremely large gains during the less frequent but devastating drawdowns. However, when executed correctly, and in the appropriate size relative to the overall portfolio, the long-term benefits in terms of CAGR can be substantial, as investors can maintain a greater allocation to equities due to the risk reduction from direct hedging.
At present, return targets for state pension funds are 7 percent or greater. Looking to the future, it is unclear how pension funds with a required return of 7 percent will be able to maintain or improve funded status with standard diversification. Today’s exceptionally low bond yields do not bode well for achieving such return targets with a typical allocation to fixed income. To make matters worse, such balanced portfolios are likely to provide less protection than in 2008 during a future crisis of similar magnitude. The next financial crisis with a 30 percent or greater decline in equities may deliver a fatal blow.
Recent experience and longer history shows that the assumed negative correlation between bonds and equities is not as reliable as we would hope for. That means state pension funds are unlikely to achieve the 7 percent return necessary to stay afloat if they continue to blindly follow the standard diversification strategy. Rather, pension funds should explore alternative approaches to ensure that the money is there when teachers and firefighters and other essential workers choose to retire.
Until then, diversification for its own sake is not a strategy for success.
Ron Lagnado is a director at Universa Investments and a senior member of the firm's research group. He was previously a senior investment director at CalPERS.
