Pension funds look for risk protection without sacrificing returns

Pension funds want money managers to provide risk protection and higher returns at the same time.

Whether it works depends on whom you ask.

“Can you do both return and risk protection in the same portfolio? Sure,” said C. Hayes Miller, head of multiasset, North America, Baring Asset Management, Boston. “Some managers are trying to deliver the holy grail of return and risk protection. That's what we're trying to do.”

But Charles McKenzie, global head of institutional solutions, Pyramis Global Advisors, Boston, thinks pension fund executives know better. “Pension funds are walking in with their eyes wide open, they know there's a risk/return trade-off,” he said.

Several money managers offer strategies like real estate, private equity, hedge funds, bank loans and emerging markets debt as ways to both provide risk protection and generate returns.

Some of those strategies worked for the $52 billion Massachusetts Pension Reserves Investment Management Board, Boston, which raised its five-year annualized expected return to 7.9% from 7.7% and cut its risk to 12.1% from 12.4% through asset allocation changes approved in 2011, said Michael Trotsky, MassPRIM's executive director and chief investment officer.

“After looking carefully at our capital market assumptions, the expected returns for each asset class, we saw a unique opportunity to increase our expected five- to seven-year return while simultaneously reducing risk,” Mr. Trotsky said. “We did that by shifting money out of our global equity asset allocation and into value-added fixed income and hedge funds, two lower-volatility asset classes.”

Return vs. risk “is usually a trade-off, but the asset allocation changes we made in the summer of 2011 moved us down the risk scale while increasing expected return,” Mr. Trotsky added.

For MassPRIM and other pension funds, the risk of equity volatility has driven the shift in strategies. “Many plans have too much equity risk, so they're moving to risk premia,” said Mark Ruloff, director of asset allocation at Towers Watson & Co. in Arlington, Va.

“They've recognized that being in U.S. small caps, large caps, international equity and emerging markets isn't really diversification, so they have to diversify across risk premia. ... It's possible to do both return generation and risk protection; there are managers out there who can do that. It requires high governance, (and) the time, talent and organizational ability to do this.”

In January, PKA, Hellerup, Denmark, hired Acadian Asset Management to run a $450 million managed volatility strategy, with a similar focus on restructuring of the equity portfolio to lower the risk allocation to equity beta and utilize the risk budget for other parts of the portfolio. PKA, which is owned by five Danish occupational pension funds, managed about 200 billion Danish kroner ($36 billion) as of Dec. 31 (P&I Daily, Jan. 30).

MassPRIM cut its global equity allocation to 43% of total assets, from 49%. Of that reduction, four percentage points came from European and Japanese equity. “Reducing European exposure in the summer of 2011 was a very good move,” Mr. Trotsky said.

Offsetting that decrease, four percentage points went to value-added fixed income, including a combined high-yield and bank loan portfolio, emerging markets debt and private debt. “These three asset classes have since generated equity-like returns at lower risk levels.” Mr. Trotsky said.

Assisting MassPRIM on the changes was MSCI Barra, whose Barra One risk management platform was used when MassPRIM brought risk management tools in-house. “The Barra tool was unique in that it could provide risk models for multiple asset classes, including alternatives. Several other tools in the marketplace at the time were asset-class-specific, and considering the lean PRIM staff, the Barra tool was more appropriate,” Mr. Trotsky said.

While MassPRIM was able to move risk management in-house, many other smaller pension funds don't have the capacity or time to handle such adjustments. That is where some managers come in with strategies that run the gamut from managed or low volatility to dynamic asset allocation, among others, and methods that include outsourcing.

For those pension funds seeking more tactical strategies, “speed and execution are some of the drivers,” said Towers Watson's Mr. Ruloff.

“When a consultant advises a plan sponsor on allocation changes, when will they be meeting? When does the board meet to approve this? The crisis showed correlations change. When things go bad, they can go bad across all risky assets. There's a recognition that we need a better way to diversify, and many plan sponsors don't have the time or governance to deal with this, the hiring and firing of managers. There are definitely people out there who can do this.”

Baring Asset's Mr. Miller said smaller plans' inability to make tactical changes internally makes tactical asset allocation strategies attractive to them.

But, “the TAA universe is a messy group encompassing many different objectives. Most managers try to increase or decrease an allocation at the right time, but absolute-return objectives make those managers more cautious in protecting the downside, while global balanced and target-date fund managers' objective is to beat an index, with less loss protection.” Baring Asset offers a dynamic asset allocation strategy, which uses alternatives like hedge funds, real assets and private equity, “to small plans that can't avail themselves of the ability to do this,” Mr. Miller said.

Dan Farley, senior managing director and CIO for State Street Global Advisors' investment solutions group, Boston, said a plan's existing investments can provide risk protection. He said discussions with clients on alternatives and other ways to provide uncorrelated risk “are steps two or three in the conversation.”

“There are folks looking at interesting things, but tail-risk hedging doesn't always have to mean an alternatives portfolio,” Mr. Farley said.

But Curt Overway, president and portfolio manager of Oakland, Calif.-based Managed Portfolio Advisors, said pension funds are putting 20% on average into alternatives as a way to reduce risk, with suballocations that focus on real return, volatility management or broad diversification, depending on the pension fund's risk tolerance. “Navigating that alternatives space can be difficult,” he said.

MPA uses overlays to help reduce risk in a number of ways, Mr. Overway said. “It depends on the overlay. Some examples might include option overlays to reduce risk by either generating income by writing calls or providing downside protection by buying puts. Futures could be used to reduce the beta or market exposure of a portfolio or to implement a synthetic rebalancing,” like using futures to adjust the portfolio's exposures rather than trading all of the underlying positions.

MPA, Natixis Global Asset Management's overlay strategies unit, had $10.2 billion in assets under management as of March 31

While some managers offer strategies that target both returns and risk protection, others contend that that's not possible.

“A risk-free solution that delivers high returns doesn't exist,” said Chris Bartlett, partner and head of private client investments, Brown Advisory Inc., Baltimore. “The question still comes down to, in a low-yield environment, how do you keep up with inflation without moving out the risk curve?” Brown Advisory offers an outsourced CIO business targeting endowments, foundations and non-profits with assets ranging from $10 million to $500 million.

“Isn't it the same old soup all over again?” added Ted Aronson, managing principal at $22.1 billion quantitative value equity manager AJO, Philadelphia. “Call it dynamic asset allocation, call it TAA, call it market timing, but isn't that all what active management is? The world has a lot of liabilities. To think we're going to miraculously solve all that is naive.”