With equity markets continuing to underperform, Diane Knowles outlines a number of structured solutions to a long-term strategy.

The recent market environment has been a testing one for investors. During the 1980s and 1990s, a long-term strategy biased towards equities served most investors extremely well. Even though it was accepted that short-term volatility could occur, and that only over the long term would equities deliver greater expected returns, most investors became accustomed to the `good times'. Falling equity markets over the last three years, though, have led to many funds moving into deficit with their assets no longer enough to cover liabilities.

This has left many funds in a challenging situation. Many trustees and fund sponsors wish to improve security of their funds, particularly in terms of the investment returns. This typically implies moving to a greater weighting in fixed income to provide greater stability of returns, but the extra cost this implies is unattractive. Further, the prolonged weakness of equities relative to bonds and the likely long-term excess performance of equities versus bonds could mean that it would be a particularly poor time to implement the move out of equities.

Alternatively, significant equity exposure could be maintained as a long-term strategy in the recognition that equities should perform over the long term. However, any further equity weakness would be difficult, as the deficit would become even larger. So are investors only faced with moving to a strategy that implies greater stability, but also greater cost - or one that could lead to an even greater deficit if equity markets were to weaken again? There is, however, a `third way' for investors. Structuring tools are ideally placed to control risk whilst still aiming to participate in excess returns. Rather than switching out of equities into bonds and potentially `locking-in' a deficit, there are other options incorporating these tools.

Controlled equity exposure

In an ideal world, a fund would be fully invested in equities when they were appreciating in value, but would also be protected from any falls in value. Structuring tools can make this wish a possibility. A structure can be placed on an equity fund which would protect a pre-determined fraction of the capital value of the equity fund. This would give the investor confidence that equity losses on this portion of the fund would be limited to a level of their choosing. Significantly though, the structure still allows participation in equity rises when equity markets are doing well.

This collar structure, involving derivatives, allows the capital value of the equity to be protected at a predetermined level, even full capital value, whilst the implicit cost of the protection is met by sacrificing gains above a certain cap level. This structure is demonstrated in the diagram above.

These can be implemented over different time horizons dependent on the investor's view. Thus equity exposure can be maintained, but worries over whether a bear market might materialise are removed for the investor.

Matching liabilities

Rather than controlling the risk of equity exposure, investors may wish to link their portfolio performance more exactly with their expected liabilities. Traditionally, the attractions of equity investment have led funds to consider an investment in equities. Commonly, a long-term strategic benchmark is determined, with a fixed exposure to equities and bonds, frequently using tools such as asset liability modeling. This benchmark is chosen as it is expected to meet the risk/return objectives of the fund. However, a fixed approach to setting a long-term strategy can lead to the fund being exposed when equities do fall significantly in value.

Alternatively, an investor can continue to look to benefit from the greater expected return from equity assets, if a dynamic asset allocation process is used which varies exposure over time, with the ultimate objective of ensuring the value of the assets will always be sufficient to meet the liabilities.

The extent of exposure to the equity assets and bond assets is formulaic rather than, for example, determining exposure based on the economic environment or market valuation. This also means that sentiment is removed from the decision- making process. The mechanism allows greater participation in the equity assets during good market conditions, but reduces exposure as market conditions deteriorate, thus protecting the fund.

The initial split between equity and bond assets is dependent on the investor's appetite for risk. For example, suppose a fund's assets in relation to its liabilities are currently able to match it, i.e. the liabilities are 100% covered. Further, the investor believes that it is highly unlikely that the equity assets will fall by more than 15% on a daily basis. However, they would be uncomfortable if the asset value were to reach a level where it covered less than 90% of the liabilities - which specifies a `floor' level for the trading mechanism.

This worst case scenario determines the initial exposure to the equity assets. The amount in equity assets is chosen so that if they were to fall by the 15%, then they could be switched into bond assets and the value of the assets would still be no less than 90% of the liabilities. In this example, if 67% were invested in equities which then fell by 15%, the loss of value at the total fund level would be 10%, so maintaining the 90% coverage of liabilities required. In this manner, the investor can have confidence that the asset value will never fall too far below that required to meet the liabilities.

However, it has to be recognised that if equity assets were to suffer a significant fall, triggering a complete move into bond assets, the fund would then be fully invested in low-risk bond assets. At the same time, the asset value would only be 90% of the liabilities so other options rather than investment returns would be required to make up the difference between asset and liability values.

Conversely, when equity assets are performing well, the value of the portfolio would increase and thus a greater proportion of the portfolio could be invested in equity assets. An upper band could also be chosen by the investor, at which point profit is taken on the equity assets by switching into bonds with a new higher minimum floor level. For example, it could be when the asset value reaches 110% of the liabilities that the investor locks in a new minimum floor of 100%.

This process would provide an investor with the opportunity to benefit from the long-term expected return from equities, while also ensuring that the value of the assets will never fall too far below that of the liabilities.

Risk and return

Investors should consider all available asset classes and investment techniques in order to meet their long-term objectives. The advantages of structured approaches, frequently involving derivatives, to target specific risk and return objectives have yet to be fully realised. These tools can control the risk associated with investment in growth assets, whilst still allowing an investor to participate in the expected long-term gains.

Diane Knowles is Strategic Solutions Director at Schroders plc in London.