Double Digit Equity Returns 2019 YTD — how do you protect your equity position for the rest of the year?

by and | Apr 9, 2019 | bytesize, Derivatives, Featured

With both international and US equity markets up approximately 15% year-to-date reversing most of the 4th quarter 2018 correction, many plan sponsors are asking themselves “should we consider any changes to protect the equity gains that we have received?”

Most pension plan sponsors, however, haven’t seen a strong improvement in their pension funding status since the beginning of the calendar year. This comes as a result of declining discount rates (i.e. declining interest rates and credit spreads) that have increased their liability values. Thus many plan sponsors, especially those on glide paths, may be staying the course as they rely on the plan’s funded status to dictate changes in asset allocation.

So, what are some options for consideration if plan sponsors want to protect their equity position for the year?

One choice would be to reduce the amount of a plan’s equity holdings. Selling now will lock in the gains for that portion of assets being sold. However the choice of where to invest those proceeds will need to be considered. If a plan sponsor is trying to increase their hedge vs. future interest rates movements, then buying additional hedging assets could make sense. However if these assets are still needed to drive growth, investing in fixed income now after the recent sharp decline in long interest rates may not be wise as these assets will lose money if rates were to increase. That would leave cash, alternatives, or other equity segments as potential options, but those may not make sense either.

A second choice would be to use equity options to protect your position. This can be done in many different ways and can be designed in a cost effective way. One such strategy would be to sell off equity upside beyond what a plan may expect or need to purchase some level of down side protection. As an example, a plan sponsor could sell equity returns over 8% from current levels in exchange for protecting the first 10% of downside over the next year for a zero premium today.

Another strategy would be to use equity derivatives to change the effective asset allocation of a portfolio without moving physical assets. For example, one can use futures to change a 70% equity/30% fixed income portfolio into the economic equivalent of a 50%equity /50% fixed income portfolio without incurring the expenses of selling and buying physical assets. Thus the position can be easily reversed if market conditions would warrant a higher equity position.

With uncertainty in the global economy looming, why not lock-in 2019’s positive equity returns now regardless of what discount rates do? Using strategies as described above, pension plan sponsors can effectively protect their equity gains and still leave room for a certain level of additional positive returns. If you’d be happy with a 15% return this year, now is the time to celebrate and lock it in for 2019. It’s important to act quickly as the times can quickly change.

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