Pension Funds Insider

Pension Funds Insider brings the latest pensions news and industry insights; from investment and governance updates to new mandate appointments and pensions regulatory information.

Leverage, risk, and investment performance at large pension funds

Image for Leverage, risk, and investment performance at large pension funds pension funds

Alex Beath reveals the findings of a study in to the use of leverage and how it contributes to performance and risk.

Leverage (or gearing) remains the unspoken topic in pensions and investments. While risk is top of mind and openly discussed, its little brother leverage remains locked away, hidden from view. This fact is, on the face of it, strange; risk is much more complex subject than leverage, but the fact remains.
Fact number 2. All investors have leverage. The reason is benign. If an investment is financed in any part by debt, that makes for leverage. And since nearly every company has some debt on its books, investors with equity risk are leveraged.
Fact number 3. The most sophisticated pension funds recognise this state of affairs. Rather than allow leverage to go unmanaged, they watch it carefully and understand its contribution to risk and, more importantly, asset-liability risk. By having a liability, pension funds are in a unique position to use leverage to better manage the unique risk they face.
A little over a year ago we at CEM Benchmarking performed an in-depth study of the use of leverage for our largest, most sophisticated global clients. The differences in how these funds use leverage are myriad, and so the group allowed us to identify the effects of differences in leverage and how its use contributes to both their performance and risk. What we saw was dramatic.
Did increased leverage increase asset risk? The answer turned out to be no. In fact, funds with more leverage may have even had less asset risk. The reason for this was that funds with more leverage had much larger exposures to bonds - and especially bonds of longer duration. While this increased interest rate risk, it must be remembered that pension funds are effectively short interest rates because they have a liability. Funds with more leverage also tend to have much less exposure to equities, and the two - increased interest rate risk and decreased equity risk - tend to cancel each other out.
But what matters most to pension funds aside from strong returns is low asset-liability risk, and funds with more leverage had significantly less of it. By gearing up their exposure to debt and credit, the movement of assets and liabilities are better matched, meaning that the risk of a funding shortfall was reduced. This is prudent pension management.
And so what about returns - did they suffer? Not over the period we studied. In fact, funds with more leverage may have even done better than traditional funds with more equity risk and less interest rate risk.
So is leverage bad. No. Perhaps we shouldn’t be celebrating it, but funds should be using it appropriately to do the job of keeping pensions whole.

Alex Beath - Senior Research Analyst