In 2022, we witnessed a decline in most asset classes, government bonds included. In 2023, while interest rates have still been on the rise in a bid to fight persistent inflation—particularly in the UK—equity markets have generally been recovering, albeit with some recent volatility. This seems somewhat surprising given the persistence of “inverted yield curves” in many markets throughout the year, which is typically seen as a harbinger for recession.
Figure 1: Comparative performance of MSCI World and FTSE actuaries UK gilts indices
Source: Bloomberg, FTFIBGT = FTSE Actuaries All Duration TR. NDDUWI = MSCI World TR.
The results shown are historical, for informational purposes only, not reflective of any investment and do not guarantee future results. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the results of an actual investment portfolio.
The decline in bond prices from the continued rise in rates, and the general rising trend in equity markets, mean a return to negative correlation. When in 2022 many were crying the end of 60/40, in 2023 others are now crying its revival. Will this trend continue into 2024 and beyond? Who knows?
The positive correlations of 2022 are closely related to the spike in inflation that resulted from a number of global factors. In the short term at least, price inflation has started to decline in most major economies. Longer-term, one factor to consider is climate change—many would argue that 2023 was a year that clearly demonstrated it is on the acceleration.
Thinking about the physical risk, it is certainly plausible to see a future situation where combined events related to extreme weather disrupt critical food production on a global scale. Thinking about the transition risk, it is also not implausible to expect the rapid transition to renewables to lead to future volatility in energy prices driven by fossil fuels. This may not be the only serious spike in inflation we expect to see before 2050. More broadly, as the climate transition moves us into a world of “disequilibrium economics,” a return to calm, stable and well-behaved markets being the “norm” becomes increasingly less likely.
Reflecting on all of this, you could also say that it is implausible to expect that correlations between equities and bonds will return persistently to being negative—in fact, throughout history this has proven not to be the case. We certainly see the case for diversification of growth over the medium term, and the benefits that multi-asset investment strategies can bring from this. However, when it comes to risk management, we would argue that the variable experience of 2022 and 2023 continues to highlight how unwise it would be to rely on asset class diversification alone as a risk management strategy.
Why does this matter for retirees?
When saving for retirements, if your dip in equities happens to be at the same time as your dip in bonds, this may not be of concern when you can sit and wait for both those dips to recover. When it comes to those starting to draw down on their pension in retirement, timing is everything.
Let’s consider how moving from 2021 to 2022 would have felt for a typical retiree:
- Average UK energy bills went up by +72%1
- UK state pension went up by +2.9%2 (and then +8.4% in 2023)
- If they’d bought a level annuity—no change in income
- It they’d bought an annuity linked to the retail prices index (RPI)—a potential increase in income of +13.4%3
- For a 50/50 drawdown fund, they may have seen a fall in asset values of -21%4
Faced with a pricing squeeze, they may also be advised that now is not a good time to sell their investments to fund any residual spending needs. There may also be a reduction in their lifestyle spending too. How long will this situation persist? That is not a question that can be answered. There is also the psychological impact to consider—fear of further losing the value of hard-earned savings, worry over difficult choices to make and what impact all this will have on their future.
With investment risk this doesn’t just happen to a few unlucky members, but likely a whole cohort at the same time, given that many may be invested in the same default fund or product choice.
Why hedge?
When faced with risk of a repeat of this scenario, it can be valuable to employ hedging as an effective risk mitigation technique. The use of hedging has a number of parallels with the use of insurance to protect against extreme risk. With insurance you may be protecting against the extreme situation of your house burning down. With hedging—in this instance—you are protecting against the extreme situation of market volatility causing a significant loss in your hard-earned lifetime savings.
Why hedge, rather than diversify into bonds? Hedging, by construction, is designed to pay out as and when the risk happens. If correlation between bonds and risky assets is unreliable, so is the timing of protection that they provide. If you were instead buying insurance, and your house burned down, being told by the insurance company that you would not receive any immediate claim money, because we’re in the wrong type of economic environment, would simply not be acceptable. Techniques such as hedging (or also smoothing), which are mechanistic in nature, are likely to be more reliable.
There is however no proverbial free lunch and, as with insurance, hedging does come at a cost—the reduction in investment performance when markets rise could be considered an “insurance premium” against the extreme effects of taking on investment risk.
Key questions are what is an acceptable level of risk, what is an acceptable cost, and how best can the cost be optimised.
Tools for hedging: Options and futures
Buying a put option provides insurance against a loss on a specified investment index, at a specified date. It involves paying a defined amount of money up-front (akin to an insurance premium), and receiving a defined payout if the event occurs by that date.
Using a managed futures hedge aims to provide similar outcomes. A futures portfolio can be managed dynamically over time by an experienced manager to replicate the one-sided payout of an option. This is done using the same techniques that an investment bank would use to manufacture options that they sell to investors.
Whereas an option payment for protection is up-front, in the case of a managed futures approach the cost of hedging is incurred on a regular basis over time.
With an option, the payout is clearly defined for a specified amount. With a managed futures approach the payout delivered may vary to some extent, and the exact amount is not defined. Ultimately though, the defined payout that an option can provide may not be of as much value for a fund, compared to that for an individual investor. For a pension fund where members enter a fund at a different date throughout the year, it would be practically challenging to purchase options for them individually on each of their policy anniversaries (or retirement dates), delivering benefits individually to give a defined level of payout over each of their individual policy years.
A key consequence of the defined payout is that, in the case of options, the investment bank is providing a defined payout but at a cost that is likely to be higher. The cost of manufacturing that defined payout is dependent on how volatile markets will be up until the date of option payout. The investment bank has to make an assumption about this and will embed a degree of prudence in that assumption, in case they turn out to be wrong. This is known as the “volatility risk premium,” and is generally positive when observed over the long term, hence options are expected to be more expensive than managed futures over the long term. We provide an illustration of this premium for key market indices in our usual Milliman monthly market monitor, and summarise averages for these indices over recent years below.
Figure 2: Average volatility risk premiums for major equity indices across 2019-2022
| FTSE 100 | EuroStoxx 50 | S&P 500 | |
|---|---|---|---|
| 2019 | 1.8% | 2.2% | 2.9% |
| 2020 | 4.7% | 4.4% | 5.5% |
| 2021 | 2.8% | 2.8% | 3.7% |
| 2022 | 3.3% | 4.2% | 4.1% |
Source: Bloomberg and Milliman analysis.
The results shown are historical, for informational purposes only, not reflective of any investment and do not guarantee future results. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the results of an actual investment portfolio.
One final point to make is that, for a liquid market in options, you typically have the focus around the major benchmark indices—S&P 500, EuroStoxx 50 and FTSE 100 being key examples. Futures contracts are more widely available and liquid over a broader range of indices and exposures. Wherever there is a liquid exchange-traded fund (ETF) market, it is likely that there is (or you can create) a liquid futures market, as these instruments are similar in characteristics.
Ultimately both options and futures offer viable solutions for hedging risk, albeit with their own unique characteristics.
Conclusion
Hedging is not a silver bullet, but it can add valued stability and resilience where other risk management methods are less reliable. To illustrate this point, we compare the annual performance of three indices—MSCI World, a managed futures strategy5 (that is designed to reduce losses to a less severe level, of less than 15% p.a.) and UK gilts—in the three years in the last 21 when there have been significant annual losses in equities.6 The managed futures strategy has been reliable enough to offer protection in all three of these scenarios, and provided almost double the protection of UK gilts in the most severe loss in 2008.
Figure 3: Comparative performance of selected indices, in showing individual “bear market” years, and average across “bull market” years
Source: Bloomberg and Milliman analysis.
The results shown for the MSCI World and UK gilts indices are historical, for informational purposes only, not reflective of any investment and do not guarantee future results. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the results of an actual investment portfolio.
For the managed futures hypothetical simulations illustrated, Milliman Financial Strategies Ltd. does not manage, control or influence the investment decisions in the underlying account. The underlying accounts 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. Milliman FRM does not intend the use of such indices to be construed as investment advice or a recommendation to invest in similar accounts.
Hedging does come at a cost, but there are approaches and strategy designs that can be used to help optimise this cost, to make for an attractive risk-return trade-off over time—particularly for the risk-averse investor. For the example above, in the remaining years between 2002 and 2022, the cost of the modelled managed futures strategy resulted in a reduction in average annual return on the MSCI World from 13.7% p.a. to 12.1% p.a. This is inclusive of assumed transaction and management costs.7
Just as with insurance, retirees (or soon-to-be retirees) may see value in paying for this cost, to help protect their assets in case the worst were to happen. Particularly with the memory of 2022 and the spending squeeze that came from the rapid increase in the cost of living, just when investment markets were falling.
One of the key points about this value is around timing—i.e., having a strategy that could more reliably pay out as and when the risk is incurred, instead of being dependent on economic scenarios, or potentially having to wait several years before receiving the benefits of their diversified investments.
1 Based upon UK government data. See Annual domestic energy bills – GOV.UK, tables 2.2.1 for electricity and 2.3.1 for gas, overall UK average available at https://www.gov.uk/government/statistical-data-sets/annual-domestic-energy-price-statistics.
2 Based upon UK government data. See Benefit and pension rates 2022 to 2023 – GOV.UK, available at https://www.gov.uk/government/publications/benefit-and-pension-rates-2022-to-2023. Assuming calendar years = three months of prior tax year and nine months of next tax year. We note that there is a lag in the sharp increase in inflation feeding into the state pension.
3 Looking at the increase in UK RPI from the start to end of 2022.
4 Taking the average of the annual loss over 2022 from the two indices shown in the Figure 1 above, and no fees assumed.
5 This has been modelled using the Milliman Managed Risk Strategy calibrated to a particular risk profile and with assumed futures transaction costs of 0.03% p.a. and a management fee of 0.1% p.a. More information on the strategy can be found at: Milliman Managed Risk Strategy https://www.milliman.com/en/services/milliman-managed-risk-strategy. .
6 We note that, whilst there was a significant equity market downturn in Q1 of 2020, markets had fully recovered by the end of 2020.
7 See https://www.milliman.com/en/services/milliman-managed-risk-strategy.
Disclaimer
The recipient should not construe any of the material contained herein as investment, hedging, trading, legal, regulatory, tax, accounting or other advice. The recipient should not act on any information in this document without consulting its investment, hedging, trading, legal, regulatory, tax, accounting and other advisors. Information herein has been obtained from sources we believe to be reliable but neither Milliman Financial Risk Management LLC (Milliman FRM) nor its parents, subsidiaries or affiliates warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties.
The materials in this document represent the opinion of the authors at the time of authorship; they may change and they are not representative of the views of Milliman FRM or its parents, subsidiaries or affiliates. Milliman FRM does not certify the information, nor does it guarantee the accuracy and completeness of such information. Use of such information is voluntary and should not be relied upon unless an independent review of its accuracy and completeness has been performed. Materials may not be reproduced without the express consent of Milliman FRM. Milliman Financial Risk Management LLC is an investment advisor registered with the US Securities and Exchange Commission and is a subsidiary of Milliman, Inc.