A Path Through the Turmoil

The major news stories of the day will have an impressive impact on the financial markets: Russia’s war in Ukraine, escalating China versus US competition, and the worldwide effort to control inflation. However, there are minor story lines which may show an investor a path through the turmoil: the put-spread collar, liability-driven investing, and which financial market “rules.”

The put-spread collar is one of the latest innovations offering stability to equity investors in a volatile market.[1]  Generally these strategies offer “insurance” to a portfolio. Instead of insured and insurance company, however, there are counter-parties. One party trades the upside in an equity portfolio for protection on the downside, or for income as in securities lending. The problem for the equity investor is that the only reason to invest in equities versus the enhanced bond return of the endowment or institutional model is for the upside of equities, which happens without warning and in very short bursts during an investment horizon. Otherwise, the risk is not worth the reward. If you are in equities, then be in equities through the ups and downs and know it’s best to eschew “insurance.”

Liability-driven Investing for Pension Plans

As you probably know, the old-style defined benefit pension plan has been mostly replaced in the private sector by the defined contribution plan, which shifts the burden of retirement financial success from the employer to the employee. Those familiar with watching the regulatory destruction of the defined benefit plan realize that the asset side, the investment portfolio, needed an equity return, rather than a bond return, to grow successfully and stay comfortably ahead of payments to beneficiaries. The liability side, the present value of future obligations, was made heavily dependent on current interest rates through regulation even though the obligation to pay was over 20 years or more. The gradual decrease in interest rates from the 1980s to the recent past increased the calculation of the present value of future obligations beyond the ability of the asset side to grow as measured annually.

For decades, private-sector companies in the US and UK have been trying various methods of funding their present value of future obligations without going bankrupt themselves. About a third of workers enrolled in a private pension in the UK have a defined benefit pension plan and about 20% of private sector workers in the US do, too.[2] The regulators in the UK thought they had come up with a scheme to protect defined benefit plans from the escalation of the present value of future obligations when interest rates fell: liability-driven investing (LDI). To help struggling plans, the regulators approved leverage within the scheme and felt so strongly as to recommend their adoption. Well, it worked. UK plans adopted the scheme.

However, the present environment isn’t falling interest rates but rising interest rates. The problem with leverage, or debt, is that if the “bet” starts to go wrong then the counterparty asks, rather demands, more margin, or capital to be placed on deposit with the counterparty by the pension sponsor. Panic ensued and this corner of the investment world did eventually bring down a newly formed UK government.

One Market to Rule Them All

Which financial market “rules,” as in “one ring to rule them all”? The worldwide equity markets, at approximately $64 trillion (US: $20 trillion), are much larger than the commodity markets. The worldwide bond market, at approximately $120 trillion (US: $46 trillion), is mostly made up of sovereign, supranational and agency (SSA) issuers. The size of the currency markets is harder to determine. In the US the money supply as measured by M2 is approximately $20 trillion; however, the amount of notes and coins of US currency in existence worldwide is only $2 trillion. The trading in currencies is what makes the currency market the ruler: $6.6 trillion per day.[3] Currency markets can swing bond markets, and bond markets can swing equity markets. Even with, or perhaps because of, the additional volatility, stocks offer more attractive return potential.

There are three reasonable actions an investor can take while watching and reacting to the major news stories. One is to not burden an equity portfolio with an “insurance” drag, a second is to be mindful of the unintended consequences of the regulatory state’s actions, and a third is to try to concentrate on the higher-quality equity market which, while being buffeted by the larger currency and bond markets, still has its niche.

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[1] Steven M. Sears, “How a ‘Put Spread Collar’ Protects Your Portfolio, Barron’s, September 26, 2022, p. 36.
[2] “Who Blew Up Britain’s Pension Fund?” WSJ, 10/13/22.
[3] Christopher High, Concentio Capital Management, LLC, 9/22/22.