Hedging pays off as economic outlook darkens

Spirit Super general manager strategy and risk Paul Docherty warns that economic recession is still not being fully reflected in corporate earnings forecasts.

This is despite a further sell-off on Wall Street this week ahead of third-quarter corporate earnings announcements.

Docherty warns inflation will likely be higher and more persistent than the market expects and that interest rates will stay higher, affecting corporate earnings.

"And earnings downgrades would potentially cause another leg down in equities," he says.

He notes that the  plunge in equity and fixed interest markets this year has been to do with interest rates.

"It's predominantly a repricing because of interest rates rising."

"What we haven't seen yet is a significant repricing effect because of a downgrade in earnings expectations.

The former finance professor reckons the inflation-fuelled market rout has focused everyone on whether inflation has peaked or not rather than what will happen to markets.

"What's currently embedded in market prices is the expectation that the moment inflation peaks, it's going to revert very quickly back to somewhere only slightly above its recent normal range of around two per cent," he calculates.

The investment strategy and risk specialist thinks some of the pressures seen across markets - from both the supply and demand perspective - are structural changes in which case inflation will likely revert to a higher, longer-term rate.

"This, in turn, will push the central banks to act a little differently to what they've done across the last 30 years where inflation has been benign," he states.

"And that affects how we think about future discount rates."

He thinks inflation is likely across the medium term to be more persistent than markets expect, and this will lead to a compression in corporate earnings.

"Labour costs and input costs are rising - particularly in the US - and ongoing congestion in global supply chains are pushing prices up."

Yet, Docherty argues that analyst earnings forecasts for the next one to two years are still optimistic, which means markets are pricing in a soft landing rather than a hard recession.

"Now, I'm not going to sit here and be the ultimate bear and say, I think we're in for global economic disaster. But I think if we evaluate the risks to corporate earnings versus the current forecasts, there is a greater probability of possible earnings downgrade than an upgrade. And that's going to harm risk assets."

Hedging bets

Hedging in tumultuous times takes energy.

Docherty said one difficulty protecting against downside risk is that the cost of hedging is captured by the Your Future Your Super performance test.

The most common way to hedge risk is by holding put options - they are a form of insurance.

"And as with insurance, your expected return on put option protection is negative," he explains. "You don't take out an insurance policy expecting that the claims you submit to your insurer will be more than the premiums you pay.

"It's the same in financial markets in that the idea of a downside risk protection strategy is to smooth the returns but not to increase the average return. It will slightly decrease the average return in the long term."

The trouble is in the context of the performance test, there is no benchmark for put options, and the expected return is negative.

So the test is detrimental.

But Docherty points out that Spirit doesn't manage its portfolio just to the performance test. The test is just one more constraint.

His top priority is still meeting return objectives.

But it does mean that he needs high conviction across the portfolio and is seeking to add active returns everywhere Spirit actively takes on the risk.

"If we're adding value in other parts of the portfolio, that can partly offset the cost of insurance."

On his estimates, the fund's balanced option outperformed the Your Future your Super benchmark by about 120 basis points across the last year while maintaining hedging.

In some funds, he says, hedging is a permanent part of their portfolio that sits passively.

"We are trying to embed more of our dynamic outlook into our strategy so that hedging is not just a passive overlay because that creates the expected drag. But it's something that we can turn on and off based on our outlook or if the market price of this insurance becomes excessive. So, it's more of a tactical overlay,'' he adds.

Hedging has paid off big time this year.

The big payoff for put options is a global financial crisis-type event, where you have a big drawdown over a short period with a spike in volatility.

Yet that is not what is happening. At least not yet.

"This year has been a slow grind down. Since the beginning of the year, there has been a 24 per cent fall in US equity market values. To put the size and speed of this drawdown into context, we have only seen approximately half the losses that were sustained in just six months during the GFC."

"While there have been short-term bear market rallies along the way, it's almost been a linear trip from January to October to get to where we are now," he says.

The payoff for insurance is nowhere near as high when you have that gradual decline without the big spike in volatility.

"That means while that protection has provided some benefit, the nature of the drawdown in the current climate means hedges haven't afforded as much protection as during the global financial crisis.

"So there are all those nuances we consider to protect our members against risks. Downside risk protection is just one of a suite of mechanisms that we use along with diversification and allocations to alternatives."

Changing skills

Since the merger of Tasplan Super and MTAA Super to create the $26 billion fund, Spirit has increased its team by 50 per cent recruiting from banks, asset consultants and peer superannuation funds.

That has allowed the investment team to internalise its risk and asset allocation processes to better align Spirit Super's investment portfolio execution with its risk outlook.

"Allocating between asset classes allows us to move up or down the risk curve and dynamically navigate some of these risks,"

"That's why it's important to look at risk through a forward-looking perspective. Not just to adopt views from external providers but to build a bespoke internal capability that has your unique view of markets."

As with peers, diversification is the first defence against downside risk.

Tasplan had a legacy internal loan book for small Tasmanian businesses that was a key part of their portfolio strategy.

And that was long before the recent spike in demand for private debt.

As part of expanding that business, Spirit Super has internalised the management of several private market assets, and the fund is developing origination opportunities with prime manager partners.

The skill set for originating modelling and assessing private market opportunities is traditionally found in banks rather than superannuation funds. "That's why acquiring the skills that match the particular investment areas is critical when we build out our internalisation platform,

Does coming from an academic background help him?

In his view, a well-functioning investment team needs diverse backgrounds and ways of approaching problems.

"I think doing a PhD and academic research is a process where the rigour of your analysis is peer assessed- quite an adversarial process - which builds a degree of discipline around thinking and quantitative analysis. "My almost 15 years in academia allowed me to develop models to better understand the drivers of investment returns."