Staying the course: Lessons during the crisis

Background

After many global share indices broke new records after one of the longest bull markets in history, the first quarter of 2020 sees capital markets in turmoil as the COVID-19 crisis unfolds. Setting precise expectations for the likelihood and severity of market crashes is impossible due to all of the moving pieces, an ever-connected global economy, and unpredictable human behaviour. The 2008 financial crisis was described as an unforeseen tail event or ‘black swan’. As the chart below illustrates, we may need to recalibrate or abandon, prior expectations.

Figure 1: Recent Market Crashes

While the speed of this latest market correction may be unprecedented, our experience in the capital markets until now suggests there are three fundamental investment themes;

1. Liquidity
2. Transparency
3. Flexibility

These principles are crucial in all market cycles but are paramount during times of crisis. They are independent of asset allocation decisions and capital market views. We describe the importance of each theme in the following sections.

Liquidity

Broadly defined as the ability to turn an asset into cash to fund liabilities (such as member pension payments), liquidity has many practical meanings and has been brought to the forefront during the COVID-19 pandemic. While funds may have reliable estimates of cash flows during normal times i.e. forecast superannuation guarantee (SG) contributions net of pension payments and member switches, the need for liquidity has skyrocketed for the following reasons:

• Members are reacting to the market crash by switching to cash¹.
• The Australian Government has approved early access to superannuation of up to $20,000 per person affected by the COVID-19 pandemic².
• As equities have fallen, many funds are forced to rebalance and buy more equities due to their strategic asset allocations (SAA). The cash to purchase these assets must come from liquidating other assets in the absence of cash or new SG contributions.
• Many funds have hedged foreign exchange exposures and must raise cash to settle FX forwards on the US dollar, which has rallied over 13% relative to the Australian over the first quarter of 2020.

The investment thesis for holding illiquid assets, i.e. that these assets should deliver excess returns as compensation for illiquidity, is currently being challenged. Only asset owners who can ride out the storm and hold these illiquid assets for the long term, will benefit from the illiquidity premia. Funds should, therefore, balance this with their need for liquid cash, particularly during times of market crisis.

Transparency

Without sure footing, or knowing where your assets stand, it’s challenging to navigate the way forward or make sound decisions.

As asset values fall, transparency is more important than ever. The nature of all assets held by a given fund may be opaque in the typical ‘fund-of-funds’ structure where a superannuation fund delegates investment management to a dozen or more asset managers.

Funds should have a total portfolio view of:

• Individual assets held including holdings common across managers
• Exposures to risk factors, including where managers may hold offsetting positions.
• Exposures excluding any netting e.g. where offsetting risks are held with separate counterparties
• Manager-level redemption periods (stated and stressed).

This ideal view of assets is often obscured due to:

• Differences in reporting formats
• Timing differences
• The proprietary nature of manager investment decisions.

Transparency is crucial for funds to make sounds decisions, identify which assets to liquidate, or hedge exposure as needed.

Flexibility

As described in the Liquidity section, the humble SAA can create issues in times of crisis. The bounds of an SAA are important from a governance point of view and ensuring that funds maintain a long term investment strategy. However, fund trustees should consider whether the forced sale of assets solely to maintain SAA is in the best interest of members.

Flexibility helps navigate these scenarios, for example:

• Revising investment policies and product disclosures to consider extenuating circumstances
• Implementing funds level derivative overlays, to temporarily rebalance asset exposures as efficiently as possible
• Allowing for dynamic asset allocation strategies or other convex strategies which can deliver protection in times of crisis, which may not neatly fit into existing SAA frameworks.

Summary

These three investment themes will help asset owners navigate all market cycles and are all related and dependent. For example, full transparency of all asset exposures facilitates the implementation of a derivative overlay to maintain target asset allocations and preserve liquidity, providing funds have the flexibility to implement the strategy.

All funds should consider their capabilities in these three aspects of investing. Milliman is here to help clients through challenging market environments for the benefit of their members.

Disclaimers

This document has been prepared by Milliman Pty Ltd ABN 51 093 828 418 AFSL 340679 (Milliman AU) for provision to Australian financial services (AFS) licensees and their representatives, and for other persons who are wholesale clients under section 761G of the Corporations Act.

To the extent that this document may contain financial product advice, it is general advice only as it does not take into account the objectives, financial situation or needs of any particular person. Further, any such general advice does not relate to any particular financial product and is not intended to influence any person in making a decision in relation to a particular financial product. No remuneration (including a commission) or other benefit is received by Milliman AU or its associates in relation to any advice in this document apart from that which it would receive without giving such advice. No recommendation, opinion, offer, solicitation or advertisement to buy or sell any financial products or acquire any services of the type referred to or to adopt any particular investment strategy is made in this document to any person.

The information in relation to the types of financial products or services referred to in this document reflects the opinions of Milliman AU at the time the information is prepared and may not be representative of the views of Milliman, Inc., Milliman Financial Risk Management LLC, or any other company in the Milliman group (Milliman group). If AFS licensees or their representatives give any advice to their clients based on the information in this document they must take full responsibility for that advice having satisfied themselves as to the accuracy of the information and opinions expressed and must not expressly or impliedly attribute the advice or any part of it to Milliman AU or any other company in the Milliman group. Further, any person making an investment decision taking into account the information in this document must satisfy themselves as to the accuracy of the information and opinions expressed. Many of the types of products and services described or referred to in this document involve significant risks and may not be suitable for all investors. No advice in relation to products or services of the type referred to should be given or any decision made or transaction entered into based on the information in this document. Any disclosure document for particular financial products should be obtained from the provider of those products and read and all relevant risks must be fully understood and an independent determination made, after obtaining any required professional advice, that such financial products, services or transactions are appropriate having regard to the investor's objectives, financial situation or needs.

All investment involves risks. Any discussion of risks contained in this document with respect to any type of product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. Investing in foreign securities is subject to greater risks including: currency fluctuation, economic conditions, and different governmental and accounting standards. There are also risks associated with futures contracts. Futures contract positions may not provide an effective hedge because changes in futures contract prices may not track those of the securities they are intended to hedge. Futures create leverage, which can magnify the potential for gain or loss and, therefore, amplify the effects of market, which can significantly impact performance. There are also risks associated with investing in fixed income securities, including interest rate risk, and credit risk.

An investment in an underlying portfolio, whether with or without Milliman Managed Risk Strategy (MMRS) is subject to market and other risks and no guarantee or assurance is given by Milliman AU or any company in the Milliman group that the use of MMRS in connection with an underlying portfolio will not give rise to losses or that the performance of the MMRS in relation to the underlying portfolio will remove volatility completely or to the extent depicted in an illustration or fully replace losses in the underlying portfolio or to the extent depicted. While generally assets used in connection with the MMRS are liquid, this may not be the case in all circumstances. Further, during periods of sustained market growth, the return to clients from the combination of an underlying portfolio and MMRS should be less than if a client had no MMRS.

Any source material included in this document has been sourced from providers that Milliman AU believe to be reliable from information available publicly or with consent of the provider of the source material. To the fullest extent permitted by law, no representation or warranty, express or implied is made by any company in the Milliman group as to the accuracy or completeness of the source material or any other information in this document.

 

Past performance information provided in this document is not indicative of future results and the illustrations are not intended to project or predict future investment returns.

Any index performance information is for illustrative purposes only, does not represent the performance of any actual investment or portfolio. It is not possible to invest directly in an index.

Any hypothetical, back tested data illustrated herein is for illustrative purposes only, and is not representative of any investment or product.

Results based on simulated or hypothetical performance results have certain inherent limitations. Unlike the results shown in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of certain market factors such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown.

For any hypothetical simulations illustrated, Milliman AU does not manage, control or influence the investment decisions in the underlying portfolio. The underlying portfolio in hypothetical simulations use historically reported returns of widely known indices. In certain cases where live index history is unavailable, the index methodology provided by the index may be used to extend return history. To the extent the index providers have included fees and expenses in their returns, this information will be reflected in the hypothetical performance.

---

¹https://www.investmentmagazine.com.au/2020/03/unisuper-members-switch-2-billion-into-cash/
https://www.professionalplanner.com.au/2020/03/sunsuper-sees-overwhelming-flow-of-unadvised-members-flocking-to-cash/

²https://www.ato.gov.au/Individuals/Dealing-with-disasters/In-detail/Specific-disasters/COVID-19/?page=2#Earlyaccesstosuperannuation