Focus shifts to 'things you can control' after meltdown exposed portfolio vulnerabilities
Risk management has begun to eclipse investment returns as the primary focus of a growing number of U.S. pension fund executives, reflecting lingering concerns over just how vulnerable institutional portfolios proved during the market's recent meltdown.
Some industry veterans say that shift will amount to a cultural upheaval, prompting significant changes in fund governance, asset allocation, rebalancing and portfolio construction.
A focus on things “you can't control at the end of the day” — optimizing returns — is shifting to “things you can control as an investor: your governance process and the amount of risk you want to have in your portfolio,” noted Bruce Curwood, Toronto-based director of investment strategy with Russell Investments.
The double-barreled punch investors absorbed from capital markets over the past decade is driving that change. The market plunge in 2001 and 2002 distracted the U.S. pension industry from its decades-long focus on investment returns, but with stocks rebounding smartly there was little follow- through in terms of bolstering risk management, said Neil Rue, a Portland, Ore.-based consultant with Pension Consulting Alliance. Now, coming off a second market disaster in quick succession, “there's an urgency,” he said.
Above and beyond tweaking portfolios, pension funds are mulling far-reaching revamps of their organizational structures in order to manage risk more effectively, Mr. Rue added.
The biggest ripple effects are likely to be seen among public funds, where a combination of severe underfunding and fewer regulatory constraints could leave plan sponsors maintaining a relatively more aggressive risk posture than corporate pension funds.
Investment consultants cite the $36.7 billion Alaska Permanent Fund Corp., the $74.4 billion State of Wisconsin Investment Board and the $24 billion South Carolina Retirement System as early adopters of new post-crisis risk management approaches, with a number of others — led by the $218.5 billion California Public Employees' Retirement System — moving to join the fray.
The whole notion of risk hasn't been given the same “time, attention, love and care” that investment returns have gotten over the years, but that's changing, said Karyn L. Williams, a managing director and principal with Santa Monica, Calif.-based investment consultant Wilshire Associates Inc.
A growing number of institutional investors have “gotten religion,” concluding they can't sit idly by and allow these volatility shocks to take them by surprise, agreed Andrew Lo, a professor of finance at the Massachusetts Institute of Technology and chief investment strategist with Boston-based money manager AlphaSimplex Group LLC.
As a result, more attention is being paid to process and systems. Nebulous pre-crisis governance pledges of “prudence” and “reasonable” oversight are giving way to detailed risk management programs, with frameworks that allow risks to be identified and measured, while holding everyone from board members to the plan's investment staff accountable for implementation, said Ms. Williams.
More and better risk controls are a priority, after institutional investors found their funds less protected in 2008 than they had hoped, said Michael Trotsky, executive director of the $45.5 billion Massachusetts Pension Reserves Investment Management board in Boston. PRIM officials are working to identify and implement a risk measurement system that would “allow us to take a more disciplined approach” in responding to volatile market conditions, he said.
Meanwhile, in addition to spurring interest in risk management, the recent crisis has lowered resistance to change at the same time, some argue. Russell Crosby, retirement director of the $4 billion City of San Jose (Calif) pension plans, said the risk focus spawned by the crisis has paved the way for reforms that otherwise might have proved politically unfeasible.
After three years of effort, San Jose's City Council recently approved a plan to revamp the composition of the boards of the city's two pension plans, ensuring a majority with relevant experience in gauging an investment portfolio's risk-reward trade-offs, he said. Previously, the boards had been comprised entirely of stakeholders, from City Council members to union representatives.
That's only one aspect of the “sea change” now under way in how the pension system will monitor and manage risk, said Mr. Crosby. Elsewhere, the board's committee structure and responsibilities are being defined, internal staff is being hired and risk analytic systems are being evaluated, all with the goal of ensuring that all the risks being taken are ones “where you're going to be compensated,” he said.
Among other changes afoot over the past year or two, a growing number of pension plans have begun grouping their allocations by risk factors rather than asset segments, as a means of better gauging their exposure to market volatility. Under that system, for example, both equity and high-yield bonds would go into the same bucket, as both respond similarly to different economic environments.
Likewise, moves by institutional investors to arm themselves with better, more comprehensive information about the risks their portfolio are exposed to could have far-reaching effects, some predict.
Earlier this year, CalPERS issued an RFP for a risk measurement system provider, and on Oct. 1, Tallahassee-based Florida State Board of Administration put out an “invitation to negotiate” to providers of total fund risk models and hedge fund risk models.
Some investment consultants say the expense of those systems, and the in-house expertise needed to use the information they generate effectively, could limit their market to the biggest funds.
For those capable of using them, however, the information provided could prove a big advantage. When pension funds begin tapping into the kinds of risk measurement systems that investment banks and hedge fund firms have employed for more than a decade, it will pave the way for more sophisticated risk management, with the possibility of opting to take risk off the table when the level of risk in the portfolio is increasing, or adding risk when it's decreasing, said Mr. Saunders.
That could play into yet another ripple effect of the recent crisis: the growing attention paid to short-term market valuations and risk exposures. Terry Dennison, Los Angeles-based U.S. director of consulting with Mercer LLC, said the critical mass of volatility and economic uncertainty today leaves Mercer hesitant to base asset allocation recommendations exclusively on the long-term forecasts on which traditional portfolio construction methodologies rely. The firm is putting greater emphasis on scenario analysis as a means of helping clients respond to an uncertain environment, he said.
Erik Knutzen, the chief investment officer with Cambridge, Mass.-based investment consultant NEPC LLC, said his firm has long argued for a risk-budgeting approach to asset allocation, with a prime goal of reducing the equity risk in clients' portfolios. For NEPC as well, stress testing and scenario analysis, as well as liquidity analysis, have been increasingly important tools in helping clients think through potential outcomes in extreme environments, he said.
Identifying risks may be one thing, but adjusting portfolio allocations in response to changing risk exposures remains another — quite foreign — thing, many argue.
A 60-40 equity/fixed-income split can be high risk at some times and low risk at others, but most investment processes are “not really structured to adapt to changing risk very well, noted Andre Perold, George Gund Professor of Finance and Banking at Harvard Business School, Cambridge, Mass., as well as a founder and chair of the investment committee of Boston-based HighVista Strategies, which provides endowment-style investment management to institutions and families.
HighVista adjusts allocations to keep the overall risk of its portfolio stable. The goal is to outperform by losing significantly less than the market during downswings while giving up only a little on the upside, said Daniel Jick, managing director and CEO. The long term is made up of a series of short terms, and “sticking to a policy portfolio through thick and thin” is not optimal, he said.
While observers concede there's always the danger the industry is gearing up to fight the last war, few see any reason to believe capital markets could become calm and predictable again anytime soon.
Mr. Lo predicts more volatility to come, befitting a “time of extraordinary uncertainty.” Some factors will eventually fade, such as uncertainty about how this year's 2,300-page financial reform bill will be implemented, but others won't. For example, Mr. Lo traces the spikes in volatility seen in both August 2007 and May 2010 to the growing weight of hedge funds within globally integrated financial markets.
More than one market veteran said finding the right answers to risk management will require asking the right questions.
According to Lionel Martellini, the Nice, France-based scientific director of EDHEC Risk Institute, the widespread pain institutional investors suffered in 2008 wasn't a failure that can be fixed by coming up with an even more sophisticated diversification mix. It was more a case of too many people equating diversification with risk management, he said.
Diversification was never meant to be a panacea for markets such as 2008, where almost every asset class and market segment was falling 20% to 30%, Mr. Martellini said. Instead, diversification has to be combined with other forms of risk management. These would include hedging, by matching assets and liabilities, and insurance, or protecting against tail risks at the cost of some upside potential, he said.
The pension world's loss of faith that diversification can create a “portfolio safe for all seasons” has boosted interest in the tail-risk insurance strategies provided by Pacific Investment Management Co., Newport Beach, Calif., said Vineer Bhansali, a managing director who leads PIMCO's tail-risk efforts.
By allocating to hedges that go up in value as markets fall, a pension plan can harvest liquidity during dramatic market drops, gaining the crucial advantage of being able to invest in the opportunities that always accompany those panics, Mr. Bhansali said.
Without that insurance, in a scenario such as 2008, a pension fund could be forced, instead, to liquidate assets at the worstpossible time — and miss out on those opportunities, he said.
Market veterans report that tail-risk insurance is a topic of widespread interest today. Mr. Bhansali said among the top 200 U.S. pension funds, 10 likely have tail-risk insurance, another 100 are talking with providers about it, and the rest remain skeptical. Market veterans said there are more than 20 managers or investment banks offering tail-risk insurance.
For corporate defined benefit plans, the biggest ripple effect from the latest market mayhem has been to swell the ranks of believers in liability-driven investing.
The same market meltdown that left corporate plans underfunded — and therefore in a weak position to fully match assets and liabilities just now without making crushing contributions — has dramatically increased their desire to do so, if and when funding levels recover, said Charles F. Lowrey, president and CEO of Prudential Investment Management, Newark., N.J.
That has left corporate DB plans increasingly focused on risk management, with many plan sponsors' ultimate goal being to “get out of the pension business,” noted Andy Hunt, a San Francisco-based managing director and strategist with BlackRock (BLK) Inc. (BLK)'s multi-asset client solutions business. While that goal is fairly clear, the path to achieving it isn't — with the governance process under review now at many corporate plans to dynamically, flexibly take risk off the table as funding levels recover, he said.
Indeed, more corporate pension plans' investment policies now include a commitment to derisking the plans — an insurance policy of sorts to ensure yet another opportunity to do so isn't swept away by the next market disaster, noted Scott McDermott, managing director, global portfolio strategies, with New York-based Goldman Sachs Asset Management.
The outlook is more varied for public defined benefit plans. The deeply underfunded status of many public funds will force plan executives to continue taking “a lot of risk,” and the ripple effects of the recent market crisis will take the form of monitoring that risk more carefully, said Wilshire's Ms. Williams.
That has led a number of public fund clients to inquire about establishing risk management systems, and bolstering their governance structures to support that goal, she said. Trustees need to figure out what they're comfortable with in terms of potential downside losses, with specific scenario analysis helpful in that process, said Ms. Williams.