Vision Super has been using a tail-risk hedging strategy to mitigate risk to its $2.2 billion defined benefit (DB) fund from a share market downturn.
Michael Wyrsch, chief investment officer of Vision Super, is particularly concerned about the pattern of returns following stringent rules brought in by APRA in 2013 requiring the DB scheme to be fully funded all the time.
“We don’t want to go back to the councils and say we need more money to fund your employees benefit, because it’s very hard for them to plan. The problem is we just don’t know with markets when we are going to go up or going to go down,” said Wyrsch.
At the time defensive strategies such as bonds were expensive, while the cost of putting on a tail-risk hedging strategy was relatively low (the strike price used was 10 to 15 per cent below equity market levels using a relatively small budget) as it was a period of low volatility.
Tail-risk hedging involves the use of derivative instruments to reduce exposure to equities to assist performance in market downturns. In Vision Super’s case it is using an overlay managed by PIMCO.
A report from January 31, 2016, shows a fall of 30 per cent in the S&P500 would translate to a fall of less than 15 per cent at a fund level, depending on how other markets behaved (see table).
Wyrsch added that incorporating tail-risk hedging allowed the fund to have more equites than it otherwise would have been able to, and when a big downturn comes they should produce value for the fund.
“Another thing I thought about [in that period of low volatility] was the DB plans had some pretty stiff earnings return targets, so we actually reduced them last year, because we could, not because we thought bonds were better value,” Wyrsch said
“It allowed us to reduce the rate of return we need to get to meet our objectives. It actually did allow us to be better diversified, as we could materially increase the allocation to defensive assets, bearing in mind we still needed to meet our funding targets.”