In the last five years, the funded status of an average Canadian defined benefit (DB) pension plan improved to almost 90 percent from 65 percent ¹ because of one of the longest stock market rallies in recent history and interest rate stabilization. Yet many plans still remain exposed to significant and unpredictable interest rate volatility and market risk, evidenced by the recent drop in interest rates and the 2011 stock market correction.

Pension plans need to alleviate these risks in a maturing market. To mitigate interest rate risk, plans can increase their fixed income allocation, immunize cash flow, and use a derivative strategy based on predicting interest rates, for which plans are not qualified. But changing plan structure may result in a lower payoff to pensioners or higher contributions from plan sponsors. And transferring portions of liabilities to an insurer by purchasing an annuity will leave un-modelled liabilities uninsured. A going-concern plan, then, will require strategies to enhance returns even after some of these risk mitigation measures are implemented because of un-modelled liabilities and uncertain assumptions.

Market risk looms even larger as the correlation of asset classes in a multi-asset pension plan moves to one during periods of crisis. This undercuts diversification as a tool in portfolio construction. Plans, therefore, need to enhance returns, reduce the volatility of returns, surpluses, and funded status, and safeguard against large tail risks.

Pension plans constitute from 19 percent to 26 percent of hedge fund assets globally.² Many plans believe the hedge fund industry’s superior return-generating capability has been eroded by regulations and industry pressure, as seen by these funds’ sub-par performance from 2009 to 2014. Despite underperformance by most of the hedge funds, research showed a quantitative global macro strategy generated above-market, risk-adjusted returns with lower standard deviation, higher Sharpe ratios, and lower drawdowns, and it offered stable compounding rates during the same period.³

Systematic global macro strategies are long/short, which invest based on trading signals generated by quantitative algorithms, through buying or selling in spot futures and options markets, where underlying instruments are liquid stock indices, commodities, currencies, and rates. The algorithms use a variety of logics across the fundamental-to-technical spectrum. As a result, these strategies were able to grow to 12 percent of global hedge funds assets under management because of the promise of strong diversification advantages, having a low correlation to most of the asset classes, and other hedge fund strategies.⁴

Still, pension plan boards and investment staff remained reluctant to invest in these strategies because of the complex investment process and the lack of transparency. So, should a quantitative global macro strategy have a place in a pension plan portfolio? And, if so, why?

If a balanced pension plan allocates 20 percent of its assets to a global macro strategy, this would result in an increase of annual returns of one percent, with a reduction in the balanced plan volatility and a significant increase in its Sharpe ratio to 0.71 from 0.58.⁵ If the plan allocated 30 percent, the increase in the portfolio return compounded over the last 25 years would have resulted in a higher net amount than if the plan had been wound down in 2015.⁶ This could have resulted in the funded status of the average plan to increase to 135 percent⁷ instead of 84 percent at the end of 2014. Plan members, in turn, could have had a 38 percent⁸ higher benefit payout.

Because quantitative global macro strategies generate consistent relative returns, based on lower probability of negative returns and less-steep and infrequent draw-downs, they can be used to reduce the volatility of pension plans. Adding these strategies to a balanced 60:40 portfolio could materially reduce its volatility⁹ during periods of extreme volatility because of lower maximum draw-downs. Adding a 10 percent global macro allocation to such a portfolio would reduce its annual volatility by 0.88 percent. Raising the global macro allocation to 20 percent would decrease volatility by 1.7 percent.¹⁰ Over a longer period of time, lower standard deviation, along with protection from market corrections, may safeguard the portfolio compounding rate from interruptions.

The global macro strategy can also change the skews of returns to the positive side. For example, from August 2008 to February 2009, the S&P 500 Index had a monthly drawdown of 16.9 percent. The quantitative global macro, on the other hand, had a maximum drawdown of 5.8 percent.¹¹ Moreover, during the period when the average implied volatility index was 44, the monthly standard deviation of the S&P 500 was 19 percent, while the systematic global macro strategy had a monthly standard deviation of only 6.2 percent.¹² In the same way, at the time of the U.S. credit downgrade and the EU periphery debt crisis from July to October 2011, the global macro strategy monthly drawdown was 2.9 percent, with a volatility of 4.8 percent, versus the S&P 500’s average drawdown of 7.2 percent and monthly standard deviation of 17.8 percent.¹³

Over the longer term, systematic global macro strategies may avoid acute drawdowns because, unlike traditional asset classes, they’re dynamic and have a positively skewed return profile. This means they may capture upside of an up market but may have smaller down capture during stock market corrections. In other words, a non-discretionary global macro strategy captures 80 percent of the upside during months of positive returns but only 29 percent of the downside during the months when equity markets corrected.¹⁴ So, by adding a global macro strategy to their portfolios, pension plans may be able to substantially reduce their portfolio and surplus volatility over time and increase their risk-adjusted return ratios across the business cycle. The global macro allocations can also help plans protect against sharp drawdowns, which help maintain the rate at which their portfolios compound returns.

Also, by allocating assets to a global macro strategy, the probability of pension plans earning higher-than-target returns will increase.¹⁵ By allocating 30 percent of the portfolio to a global macro strategy, the probability of achieving more than six percent returns may increase to 58 percent (from 51 percent), and the chance of eight percent returns may increase to 49 percent (from 44 percent). This can help plans meet their long-term actuarial discount rates with less risk. A 30 percent allocation may also reduce the probability of negative returns to 17 percent (from 27 percent).¹⁶ The probability of above-normal returns higher than 15 percent increases to 21 percent (from 18 percent). And, an additional 1.5 percent return every year may add significant cash flows to the plan, which may help reduce the contributions from the plan sponsor and active members.¹⁷

The diversification benefits of systematic global macro strategies are explained by their long-term, or at certain times, low correlations with other assets and strategies, as they have oscillating correlation with markets, bonds, and alternative assets indices, increasing when the market rises and decreasing when it falls. These strategies also address the market outlook and the conditions current pension plans face. These include enhancing returns to meet the plan’s liabilities, reducing the risk measured by the standard deviation of returns, shifting the portfolio returns distribution to the positive side, reducing the monthly incidence of the plan’s funded status below 80 percent¹⁸, and increasing the end holding value of the portfolio.

As a result, DB plans can provide larger benefit payouts to retired members, reduce contributions from the plan sponsor and active members, and reduce the plan contribution volatility and plan surplus, which pension plan regulators target.

¹ Research note by Bob Collie, chief research strategist, Russell Investments, published Jan. 1, 2015, and Mercer statistics.
² Preqin Special Report: The Real Value of Hedge Fund Investment, June 2014 Data Pack and www.hedgefundresearch.com.
³ Barclays Hedge Index and Credit Suisse (CS) HFI.
⁴ The article has relied on some material and data from an article by Donald Steinbrugge, managing partner at Agecroft Partners, titled: “Are CTAs mumbo jumbo or additive for a diversified hedge fund portfolio?” published in www.valuewalk.com, June 1, 2015.
⁵ Estimates are based on quantitative analysis of data from CS HFI, Barclays Hedge, and JPM Capital Markets expectations.
⁶ Based on quantitative analysis of data from CS HFI, Barclays Hedge, and JPM Capital Markets expectations.
⁷ Pension funds’ assets compounded at marginal returns while keeping liabilities constant.
⁸ Quantitative calculations.
⁹ Quantitative analysis and data from Barclays Hedge and CS HFI.
¹⁰ Quantitative analysis and data from Barclays Hedge and CS HFI.
¹¹ Quantitative analysis and data from Barclays Hedge and CS HFI.
¹² www.barclayhedge.com.
¹³ Quantitative analysis and data from Barclays Hedge, CS HFI, and S&P 500.
¹⁴ Quantitative analysis and data from Barclays Hedge, CS HFI, and S&P 500.
¹⁵ Quantitative analysis, cumulative probability of achieving 6 percent and 8 percent returns, and Barclays Hedge.
¹⁶ Quantitative analysis, cumulative probability of negative and +15 percent returns, Barclays Hedge, and CS HFI.
¹⁷ Quantitative analysis and data from Barclays Hedge and CS HFI.
¹⁸ Probability tables, Barclays Hedge, and CS HFI data.