NORTH YORK, Ontario -- Value at risk has become an integral part of how the Ontario Teachers' Pension Plan Board oversees its investment managers.
After an initial step last year, the Ontario Teachers fund now uses VAR for its entire C$60 billion (U.S.$41 billion) investment portfolio.
And fund executives don't view VAR as solely a risk monitoring tool. They also use it to assign risk allocations to the fund's investment managers, and for valuing and tracking pension fund surpluses.
"It's getting increasingly difficult to put things into neat little buckets," said Leo de Bever, vice president in research and economics for the fund.
VAR allows investors to pay less attention to the buckets and more attention to the risks.
That's especially true for Ontario Teachers, where government tax restrictions on foreign investment and a huge portfolio of nonmarketable debentures have led the fund to become a leader in the use of derivatives and alpha transportation strategies.
Tax laws in Canada limit investment outside the country to 25% of assets. But by combining derivatives with Canadian treasury securities, pension funds such as Ontario Teachers can get around that restriction.
Moreover, Ontario Teachers swaps out of the returns of more than $15 billion of nonmarketable fixed-income securities into various other asset classes.
VAR works well for the fund as an oversight tool.
"This system is hypersensitive to anything that goes wrong in a portfolio," Mr. de Bever said. The response time has been drastically reduced for catching things such as incorrectly executed trades, he said.
But the VAR system also has been valuable for proactive management of its investment managers. As a result of adopting VAR, investment managers are given separate dollar and risk allocations.
Managers then are expected to outperform relative to their allocated risk, not relative to a benchmark.
The risk exposures won't necessarily be closely related to the amount of assets managed, Mr. de Bever said.
Hence, the risk allocated to an active portfolio of C$400 million in Canadian equities might be almost as much as the risk allocated to a passive Canadian portfolio of C$15 billion.
Investment managers are not always satisfied with the amount of risk they are assigned, Mr. de Bever said. But if they are given more risk to manage, they are expected to produce added return, he said. That's because the expected added value is a fixed proportion of the risk allocated to a given style.
The process begins with fund executives setting a policy asset allocation target then deciding how much of that should be indexed and how much should be active.
Using that, the fund's risk budget is set, which for this year was equal to about 3% of assets, he said.
That risk is then parceled out to the various asset classes, and then to the internal and external investment managers within those classes, he said.
"This process causes people to be much more cognizant of the risk they are taking," Mr. de Bever said.
Some managers "were shocked to see the strategies were riskier than they had in mind," when informed of what their value-at-risk calculations were.
"That's human nature," Mr. de Bever said. Human perception of risk will be less than what the numbers bear out, he said.
Others, though, weren't using up their risk allocations, he said. That isn't an issue as long as the manager is adding enough value relative to its allocated risk.
How to induce people to take the right amount of risk is an ongoing issue at the fund, Mr. de Bever said.
Ontario Teachers relies on a more complicated version of value at risk than just calculating VAR on its portfolio.
Value at risk is generally derived through statistical techniques that seek to estimate the most a portfolio will lose under certain assumptions, based on historical or simulated market behaviors. For Ontario Teachers, that is 1% of instances under a 99% confidence level. Outside of those boundaries, however, the value of assets at risk can be greater.
But Ontario Teachers calculates a VAR number that takes into account the fact that managers typically invest against a benchmark, not on an absolute number.
So Ontario Teachers subtracts from the actual investment portfolio a portfolio consisting of a manager's benchmark. That results in a series of long and short positions consisting of the manager's deviation from the benchmark. Value at risk then is calculated on that deviation, which Ontario Teachers calls "management effect at risk," or MEAR.
Each manager is expected to produce an added value that is a fixed percentage of its MEAR across the board, about 10%.
For example, Ontario Teachers recently had about C$3 billion invested in Canadian active equities with a MEAR of about C$400 million. That MEAR exposure was expected to realize about C$43 million in active management added value.
Conversely, the MEAR of its C$15 billion in quantitative Canadian equities was C$500 million, so its expected active management added value was C$54 million.
Even index fund managers are given some risk to manage their portfolios, allowing them to take advantage of optimization techniques, and to minimize transaction costs, Mr. de Bever said.
The VAR process is applied to all of its portfolios, with proxies being used for less liquid investments because VAR is highly dependent on pricing for its methodology.
Moreover, Ontario Teachers is using VAR to value its pension surplus. Liability payments are valued as if they were a short position in the fixed-income market.
VAR is calculated on the sum of the assets and liabilities, giving fund executives an estimate of the volatility of the pension surplus, he said.
"You should focus on surplus risk, not asset risk," he said.
"It's very useful in motivating people to do the right thing," he added.
Ontario Teachers uses Reuters Sailfish system, although products offered by vendors such as Askari Risk Management Solutions, New York, and Algorithmics Inc., Toronto, would also do the job, Mr. de Bever said.
He declined to provide the exact cost, but systems such as that will cost about $500,000.
For a fund the size of Ontario Teachers' the costs of purchasing and running the system are low, he said. Moreover, cheaper systems for smaller, less complicated funds are available, he added.
The VAR calculation is performed using 11 to 13 years of daily data.