Adapting to Market Volatility with ETFs and Indexing

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

To set the scene, can you provide insight into the evolution of pension scheme portfolios?

Since the Global Financial Crisis, markets have been defined by relatively stable growth and low inflation. The change in the market environment post covid suggests we are now in a new era of greater macroeconomic volatility. Our global economies are more susceptible to a world shaped by supply constraints. While the long tail of the pandemic caused initial structural changes, those have been compounded by aging populations, geopolitical tensions, and the energy crisis. These global supply chains impact economic output and this new era is not going away, in our view.

The last few years have proven the need for Trustees and investment teams to re-evaluate their investment strategies to protect their members’ retirement incomes and to respond to the evolving needs of global demographics. Portfolios need to be more resilient and diversified, while members are requesting more choice that aligns with their desires and beliefs. Sustainability and the transition to a net zero economy is one of the most relevant examples of where this has been playing out and is becoming entrenched across the industry. Defined Contribution (DC) Schemes need to take this into account across their default strategies and platform breadth.

Looking ahead, we expect these structural changes will contribute to continued inflation pressure, cross-asset class volatility, and interest rate uncertainty. Central banks cannot solve supply-side constraints. That leaves them raising interest rates and engineering recessions to fight inflation, which is why the relationship between stocks and bonds may be more dynamic moving forward.

Amid so much uncertainty, we must re-examine retirement plan menus to build resilience for a new regime.

Diversification is clearly imperative today to navigate market challenges. How are investors thinking about diversifiers?

Investors must approach this from a whole portfolio lens, ensuring diversification is a tailored approach, specific to their overall exposures and member needs. Every portfolio is unique and will need unique levels of diversification employed within it.

We are seeing investors incorporate greater allocations to traditional sources of portfolio diversification, such as gold and commodities which have performed well during periods of higher inflation. Many of these exposures also show a low or negative return correlation to equities and bonds.

What is different in this new regime, however, is the impact and influence of mega forces. These structural forces are reshaping the way we live and work, acting as a material catalyst to incorporate differentiated sources of risk and return into portfolios alongside equities and bonds. AI, geopolitical fragmentation, ageing populations, the future of finance, and a low carbon transition are themes that investors are focusing on that bring a different factor perspective to portfolios.

The energy transition is an investment example impacting many industries and countries that could be immune to traditional macro factor shocks, as the local energy reliance and innovations to deliver more green energy are likely to retain investment for the foreseeable future.

What are the repercussions of managing a wider array of asset types?

Investors must be disciplined and have conviction in their portfolio construction process, deeply understanding their portfolio goals and not deviating or allowing scope creep to influence behaviors. Retirement investing is about protecting incomes and ensuring member investments can meet the needs of pensioners when required.

How do you see these global trends playing out in the South African market?

Globally, we are seeing more institutional investors (pensions) look to indexing investment strategies and multi-asset products to achieve their investment goals. This is primarily due to the low cost and transparency of these strategies. Importantly the growing use of Exchange Traded Funds (ETFs) is also allowing for enhanced liquidity, a core investment outcome managers are looking to deliver to their members, e.g. the Two-Pot system.

Combine this with the increase in the offshore limit to 45%, and we anticipate an uptick in ETF adoption. ETFs are uniquely placed to capitalize on this increase as greater offshore allocations may allow for greater diversification within portfolios which can help both balance risk and bring in members’ wider investment priorities such as sustainability.

Where do ETFs come into this and what are your views on these strategies?

Indexed strategies are set to remain a fundamental component of pension portfolios, complemented by innovative offerings like private markets. The current investment landscape demands a level of granularity, precision, and diversification that can be effectively met through the extensive range of exposures available on ETF platforms. The ETF wrapper is often the venue for indexing innovation, which is instrumental in unlocking new opportunities that align with the significant trends shaping the financial world today.