Equity market volatility: what are my options?

During the past year and a half, we have seen equity markets reaching new highs as the post-pandemic recovery has rolled out across the globe.

As we approach year-end, however, headwinds have emerged that could threaten the benign environment; risks such as the supply chain and capacity, increasing virus infection rates, and concerns over China all have the potential to shake equity markets.

Many DB pension schemes with equity-market exposure will have benefitted from increasing funding levels over the past year and a half which, now more than ever, poses the question: is this a good time to use equity protection?

Using an equity protection strategy could help pension schemes lock into these gains by reducing their exposure to equity-market falls whilst at the same time retaining exposure to equity-market growth. We’ve seen them implemented in a variety of different ways, with structures that are designed to offer protection from markets falling below a certain level (the ‘floor’) by selling away equity-market upside above a certain level (the ‘cap’) proving particularly popular.

Historically, such strategies have been implemented with protection expiring after a set period of time, known as static option structures. One risk, however, is that getting the timing right can make all the difference; for example, you would have had a very different outcome if you had protection which expired at the end of February last year, compared with at the end of March.

For clients who want to maintain the protection over time by rolling the positions ahead of expiry, the governance around decisions of when and how to roll the options poses an additional challenge and can act as a barrier to some clients being able to implement ongoing protection efficiently.

This may be one of the reasons we’re seeing increasing interest from clients in using systematic equity protection strategies where the options are continuously rolled, maintaining the protection over time, as shown in the chart below.

These ‘evergreen’ structures aim to reduce equity volatility over the long term, easing the timing risk and governance burden of static strategies.

Indeed, as systematic protection strategies provide a consistent level of protection over time, they could be used by pooled funds, providing smaller clients access to equity-hedging strategies.

During market downturns, the protection structure has the potential to reduce the drawdown of the strategy compared with equities, with lower volatility, whilst retaining meaningful participation in equity market upside during market rallies. Additionally, these systematic equity strategies could offer greater potential upside in periods of strong equity-market performance compared with static structures, due to the differing terms of the upside sold and protection bought.

Ultimately, in the absence of a crystal ball, calling the next market downturn is a tricky business. So, for some DB schemes, equity protection strategies could offer a hedge against tail risks whilst retaining market exposure.

We believe systematic strategies offer a potential route to protection with lower ongoing governance and lower timing risk, in a way that is more accessible for smaller clients than static structures.

• The value of an investment and any income taken from it is not guaranteed and can go down as well as up; you may not get back the amount you originally invested. For illustrative purposes only. Reference to a particular strategy is on a historic basis and does not mean that the strategy is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any strategy.