The challenge with conventional de-risking

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.


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