The Challenge: Generating Sufficient Returns
BY BOB PARISE, Northern Trust Asset Management
Increasing pressure to reduce risk coupled with a challenging market environment will make generating sufficient pension returns harder in the coming years. Volatility has returned, the yield curve has flattened and global growth has slowed — all of which can contribute to lower future returns.
To illustrate the magnitude of these negative shifts in the return expectations, we utilized our five-year risk and return forecasts to simulate various optimal portfolio outcomes. Compared to just 10 years ago, these hypothetical diversified portfolios have a ~2% drop in returns across all levels of risk, which compounded over time, can become a significant unfunded liability for pension plans.
Historical approaches to bolster returns generally involved increasing certain risk exposures, such as adding alternative and private investments. However, some plan sponsors are limited in the amount that they can increase their risk budgets. Others are already at their liquidity limits for more aggressive allocations. These limitations diminish a plan sponsor’s ability to meet its target return objectives of 6% to 7.25% without taking too much risk.
The Solution: Quantitative Multi-Factor Strategies
Multi-factor strategies could offer a consistent alpha contributor to your equity allocation without increasing your pension’s risk budget.
While markets can be cyclical, in our 20+ years of managing factor-based strategies, we’ve found quality to be a diversifier that potentially makes outperformance more consistent over varying returns cycles.
Similarly, in rising rate and low return environments, we have seen the same pattern of high excess returns, primarily in the low volatility and quality factors (Exhibit 2). While not all of these factors may align with your plan’s objectives, this framework can provide a helpful guide to gauge whether your portfolio is aligned to capture these potential drivers of outperformance.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Northern Trust Asset Management or TEXPERS. Click here to read Northern Trust Asset Management's full disclosure.
About the Author
Bob Parise is practice lead, Public Funds & Taft-Hartley Plans at Northern Trust Asset Management and a member of the Business Leadership Council. Parise has more than 24 years of financial industry experience, most of it at J.P. Morgan Asset Management and its predecessor firms. He earned a bachelor's degree in Finance from Western Illinois University and a master's degree from DePaul University. He holds Series 3, 7, 24, and 63 licenses.
Increasing pressure to reduce risk coupled with a challenging market environment will make generating sufficient pension returns harder in the coming years. Volatility has returned, the yield curve has flattened and global growth has slowed — all of which can contribute to lower future returns.
To illustrate the magnitude of these negative shifts in the return expectations, we utilized our five-year risk and return forecasts to simulate various optimal portfolio outcomes. Compared to just 10 years ago, these hypothetical diversified portfolios have a ~2% drop in returns across all levels of risk, which compounded over time, can become a significant unfunded liability for pension plans.
Historical approaches to bolster returns generally involved increasing certain risk exposures, such as adding alternative and private investments. However, some plan sponsors are limited in the amount that they can increase their risk budgets. Others are already at their liquidity limits for more aggressive allocations. These limitations diminish a plan sponsor’s ability to meet its target return objectives of 6% to 7.25% without taking too much risk.
The Solution: Quantitative Multi-Factor Strategies
Multi-factor strategies could offer a consistent alpha contributor to your equity allocation without increasing your pension’s risk budget.
What Are Multi-Factor Strategies?
Factor-based, or quantitative, equity strategies seek to outperform a benchmark by exploiting market anomalies and behavioral biases using proprietary and quantitative models to select securities, construct portfolios and manage risk to deliver targeted outcomes. |
| Click image to enlarge. |
Why Invest in Factors Now?
We do not advocate trying to “time” factors over short periods of time, but it is important to note the cyclical nature of factor returns. Factors have tended to perform well in any economic environment, but they have historically been at their best when the economy is moving out of periods of high expansion (Exhibit 1). |
| Click image to enlarge. |
While markets can be cyclical, in our 20+ years of managing factor-based strategies, we’ve found quality to be a diversifier that potentially makes outperformance more consistent over varying returns cycles.
Similarly, in rising rate and low return environments, we have seen the same pattern of high excess returns, primarily in the low volatility and quality factors (Exhibit 2). While not all of these factors may align with your plan’s objectives, this framework can provide a helpful guide to gauge whether your portfolio is aligned to capture these potential drivers of outperformance.
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| Click image to enlarge. |
Learn more about multi-factor strategies on northerntrust.com
or contact Bob Parise.
Bob Parise is practice lead, Public Funds & Taft-Hartley Plans at Northern Trust Asset Management and a member of the Business Leadership Council. Parise has more than 24 years of financial industry experience, most of it at J.P. Morgan Asset Management and its predecessor firms. He earned a bachelor's degree in Finance from Western Illinois University and a master's degree from DePaul University. He holds Series 3, 7, 24, and 63 licenses.
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