State Super chief executive John Livanas is fine-tuning the pension fund’s aggressive tail risk hedging strategies as increased volatility has made protection against adverse market events more expensive.
Livanas said the $44 billion superannuation fund had put in place a program of downside protection, diversification and liquidity management, that paid off well in the current market environment.
The CEO said that because State Super, as a closed defined benefit hybrid fund, has significant cash outflow each year of around $5 billion, it required careful management.
“We thought really carefully about what would happen in a market environment where a falling market was exacerbated by increased member retirement,” he said.
As a result, they dialed-down the fund’s growth-orientated investment strategies by using hedges, currency, and cash flow management to protect against impairment.
“We still need growth strategies to achieve our targets, and paradoxically, a strong defensive program allowed us to actually take more upside risk,” he said.
The strategy was effective.
Portfolio returns were up 2.2 per cent for the 12-months to the end of the March – the period immediately following the collapse in financial markets. This compares to the returns for the average accumulation fund which dropped between 5 to 9 per cent as billions of dollars were wiped from the value of equity markets following the coronavirus outbreak.
Livanas put the performance down to the hedge that protected the portfolio against an extreme market event.
“We managed to avoid deep drawdowns on the portfolio,” he said. “We have several strategies in place both for the way we construct our asset allocation, the way we use derivatives, the way we hedge our exposure with defensive overlay and currency.”
How investors use foreign exchange as an effective capital hedge will also be discussed by PE Investment’s Andrew Harrex at the Fiduciary Investors Digital Symposium next week.
“All funds struggle with the cost and value of tail risk,” said Livanas. “In our case, the market sell-off was so dramatic that pretty much all of our hedges were in the money and protected the portfolio. We have monetised these deep in the money options opportunistically leaving cash to pay members or perhaps judiciously buy cheaper equities.”
But now, the CEO is faced with a dilemma.
“We have unwound most of the hedges and it is extremely expensive to purchase these options when the market volatility is still high,” he said. “On that basis, we are thinking about how much risk we can take given that our portfolio is relying on the same level of defensiveness that we had before.”
While the dramatic fallout from the pandemic hasn’t affected State Super as much as other funds, the defined benefit fund has still lost capital. State Super can tolerate volatility, but a sustained fall is a concern because it has been cash-flow negative since 2004 and has a funding gap.
“We always worry about liquidity, so we are now perhaps more defensive in our investment strategy outlook,” Livanas said. “The path we take needs to be more moderated.”
Even so, his investment team is still investing in equities to help generate returns above inflation.
“We believe that this period of disruption is going to create significant dispersion in returns, and this means actively managing asset allocation and appointing active managers,” he said. “If you want returns, you will have to be much more active with equities, the rest of the capital structure is not going to give it to you.”
Livanas also said the fund had carefully considered its allocation in unlisted assets. “Our process of ensuring we pay the right price and execute appropriately in investing in illiquid assets is harder for a fund like ours that doesn’t have the same long-term horizon of massive growth.”
Almost half of the portfolio is allocated to liquid growth assets like equities. The fund currently has 36 per cent allocated to alternatives and a 34 per cent exposure to foreign currency as a risk management tool.
The topic of currency will be discussed at the Fiduciary Investors Digital Symposium which will be run as an interactive live-streamed event across two sessions on both May 19 and 20.
Register now to secure your tickets for $250 + GST. Your registration includes unlimited access to our multimedia content hub, a dedicated podcast series, video recordings of each session, thought leadership and papers and exclusive editorial coverage. The program will also be accredited with CE/CPD hours.
View the full program and speaker line-up at www.fiduciaryinvestors.com.au