EDINBURGH The ability to consistently turn active risks into excess returns is proving elusive to most U.K. pension funds, according to a WM Performance Services survey released in April.
Of the 250 U.K. pension funds surveyed which have a total of about £450 billion ($904 billion) in assets only 13% achieved an information ratio of at least 0.5% in two consecutive rolling three-year periods from Jan. 1, 1999, to Dec. 31, 2005. Furthermore, when considering whether some funds routinely fare better than others at implementing their investment decisions, the answer was a resounding no, according to the report that accompanied the surveys release.
Information ratio is defined as the funds performance relative to its strategic benchmark and divided by the active risk taken. For example, a fund with excess return of 1% above a benchmark and taking an active risk of 2% would have an information ratio of 0.5%.
When examining more closely those funds which have delivered good and poor information ratios, we found that theres not much correlation not in terms of whether funds are able to add value through active management or the fund structure itself, said Alastair MacDougall, executive director of WM Performance in Edinburgh. We considered to what extent the funds used multiasset managers, specialist managers or something in between, such as a core-satellite strategy. We also looked at factors such as the percentage of assets that were internally managed.
At the end of the day, it all comes down to which active manager you have at what particular point in time, rather than what fund structure you have or the levels of active and passive management employed, added Mr. MacDougall, lead author of an analysis on the survey.
Pension fund sponsors and trustees particularly those in the U.K., the Netherlands and elsewhere in continental Europe have been paying closer attention to information ratios in recent years as a way to better monitor added value, Mr. MacDougall said. The information ratio is particularly useful because it is a way to separate beta and alpha while taking into account decisions by trustees, consultants and managers involved in the entire investment process.
Griff Williams, London-based institutional product strategist for Pioneer Investments, said, When it comes to manager selection, trustees are increasingly using information ratios as a first screening. (Information ratios) are an indication of manager skill.
According to the survey, high performers defined as pension funds that produced at an information ratio of least 0.5% for two consecutive rolling three-year periods typically achieved information ratios ranging from 0.7% to 1.9%. The low performers those that produced a negative information ratio for two consecutive rolling three-year periods had information ratios of -0.2% to -1%.
WM Performance defined a good information ratio as about 0.5%, or that of a typical fund in the 25th percentile. Of the funds surveyed, 38% achieved an information ratio of at least 0.5% in at least one of the two rolling three-year periods examined. Forty-eight percent failed in both of the three-year periods.
It is clear that funds across different size bandings, structures and active/passive mix are capable of producing both good and poor information ratios, according to the survey analysis.
In tandem with risk budgets, pension fund trustees often use information ratios to target risk to those areas where they perceive the best opportunities for reward exist, according to the analysis.
But what seems to be happening is that active risks taken with (external) managers, in general, have not been rewarded, Mr. MacDougall said. We need to get more realistic in terms of performance expectations.
Mr. Williams, who was formerly a senior investment manager of the £17 billion ($34 billion) Railways Pension Scheme, London, added that the two most reliable and consistent sources of information ratios have been the truly active managers particularly those with both quant and fundamental skills to bring to the table, and at almost the opposite end, the enhanced quant managers.
The pension funds own governance structure and risk budget can play an important role in its information ratio. In a liability-driven investing framework, for example, the information ratio resulting from the decision to move away from a funds liability profile is often not considered at all.
If (a pension fund) departs from its true benchmark, which is the future liability stream of the scheme, then it is taking on active risk, Mr. Williams said. That needs to be analyzed and this allocation of this risk should be managed in a transparent and considered way. The expectation of the reward achieved as a result of this should be central to the strategy-building thought process.
Within the three years ended Dec. 31, 2005, no investment structure featuring externally managed assets dominates in terms of providing superior risk-adjusted returns gross of management fees, according to the survey. The only asset management structure that appears superior is the internally managed group, with about 75% of those surveyed achieving positive information ratios gross of management fees.