The majority of schemes we come across are worried about market falls. This is truer now than ever with markets at, or near, all-time highs but with worrying events on the horizon.
Funding levels are better than they were a few years ago, and governance standards are higher meaning that trustees know that no decision is still a decision.
As a result, trustees are considering taking some money out of equities to “de-risk”.
I am going to pose a couple of questions: Is this really de-risking? If so, is the de-risking consistent with the worry that drives it?
Is this really de-risking?
Let’s take an example where a scheme decides to take 10% out of equities and put it in cash.
In this situation, the scheme is simultaneously 10% less exposed to market falls but is also 10% less exposed to market rises. If we think about de-risking in terms of reducing exposure to losses from equity market falls, then this is clearly de-risking. But what happens if the market goes up? In that situation the scheme is 10% less well funded than it would have been and, therefore, needs an even bigger market rally to achieve its objective.
Is the de-risking consistent with the worry?
A 10% de-risk to me still shows an incredible amount of confidence in market rises. After all, 90% of the assets in this example remain in equities. I would interpret the scheme’s positioning as follows:
- The scheme wants to remain in equities as they generally believe in them
- There is a concern that growth could be muted; or
- Markets could fall and, if they do, they want to be protected
However, a 10% de-risk doesn’t meet the above for two reasons:
- It is still exposed to the full upside of equities
- It is still exposed to the majority of the market falls – if the market falls 20%, the scheme will still be down 18%
A 10% de-risk is a one-dimensional solution to a multi-dimensional objective.
Structured Equity using equity options is a way of creating a solution that is better tailored to these needs. For example:
- Having capital protection from market falls of up to 20% - i.e. if the market falls 20% over 3 years, the scheme will not lose what?
- Being exposed fully to equities up to a cap of 25% - the upside is still retained up to and well above the investment objective
This is just one example – the parameters can be tweaked to suit the needs and concerns of each scheme.
So whilst disinvesting from equities into cash may feel like de-risking, it may not be the ideal solution for your needs.