2024 Global Investment Conference: How the risk-return proposition can help portfolios perform well in a variety of market conditions

He emphasized that effective risk mitigation requires a dynamic and flexible approach, adding market-neutral funds have proven to be particularly efficient in managing risk, based on past experiences.

Read: Canadian public pension plans lead in private equity investments: report

Market-neutral portfolios are essential for pension plans, offering stability in volatile markets, as they minimize exposure to market swings and focus on generating returns through skillful selection of investments, said Tétreault. These strategies isolate alpha, providing a more predictable and stable return profile. Additionally, during market turbulence, they provide a layer of protection, aligning with the core objectives of pension plans.

In 2019, there was a significant rally in private equity, particularly in the technology space. While private equity performed exceptionally well, many investors were over-exposed to this asset class. “We noticed that the correlation between our private equity book and the NASDAQ was extremely high. We decided to implement put strategies to mitigate downside risks which protected our gains within private equity.”

In 2022, the economic climate saw bonds and equities declining simultaneously, with private market returns remaining relatively stable. Subsequently, plans soon realized they were suddenly overweight in their private market allocations. With private markets’ illiquidity, assets sold on the secondary markets were at a significant discount, reducing the returns they produced over time, he said. “We needed to find a way to mitigate tail risk events with low probability, low frequency, but high-loss potential.”

Trans-Canada Capital ran a variety of scenarios, taking into consideration worst-case outcomes, in which the average loss was between roughly 10 percent to 20 percent. The investment organization looked across asset classes and different products to find ways to mitigate some of that risk.

Read: Canadian DB plans increasingly focused on long-term goals, monitoring pension risk

To balance risk and reward, TCC implemented tail risk hedges across the entire private market portfolio. “This strategic decision to give up some potential upside in exchange for downside protection was not taken lightly but was deemed necessary to safeguard our investments against a wider array of risks,” explained Tétreault.

To achieve this, they built a portfolio comprising five to seven trades aimed at having a high benefit-to-cost ratio and expected to align with their worst-case scenarios. By implementing these strategies, the downside scenario losses were reduced by half, providing significant protection for the pension plan. “The first trade was a basket of put spreads, the second was a book of dispersion trades and the other trades included a basket of rate-linked trades. What we do here is try to maximize the hedging power for a given cost, what we call the benefit-to-cost ratio. And cost can be simply the premium paid on options or the expected negative carry on trades.”

Tétreault suggested that with risk-mitigation trades, institutional investors should consider reliability, meaning the probability of their hedging strategy protecting capital if there’s a market downturn. They should also determine the benefit, such as how protected they are from the drawdown and how much return is generated.

It’s also important for them to consider monetization. “It’s easy to put a trade in place, but you need to understand and stress test it. If there’s a really strong market downturn, what happens with your positions? Are they liquid enough? Can you monetize? And when do you monetize?”

Read: Leveraging the long-term perspective at Rexel North America

It’s important that investors have a game plan and know what to do at different levels before they put a trade in place, said Tétreault, noting they should determine the cost to benefit and just how much of the upside they’re giving up to gain protection. But he emphasized that the fit is crucial.

“When you have your plan in place, you can run a variety of scenarios with the inclusion of those risk-mitigation trades. And then look at the risk-return proposition. Because risk mitigation is about improving risk-return, it’s not necessarily about expressing a bear view.”

There are a lot of asset classes with different instruments that investors can use to review and assess strategies, said Tétreault, noting that portfolio construction is also critical. “Understand your needs and where your plan is at, what you need to do, and what’s the best way to go about it.”

He strongly encouraged institutional investors to take a partnership approach with their investment managers. “Don’t be shy to ask your managers to share thought leadership, ideas, and trades to implement within your own pension plan to hedge undesired risks.”

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