Investment Panel (October 2007) - Running the risk

Kevin Wesbroom, principal consultant, Hewitt Associates
Wesbroom is a principal consultant at Hewitt Associates, with a particular focus on pension plan redesign and new developments in the pensions arena.

Philip Best, chief risk officer, Threadneedle Investments
Best joined Threadneedle in 2007 as chief risk officer and is responsible for measuring, monitoring and reporting investment risk. He has worked in the financial markets since 1985 and has held a number of positions, including director of credit and market risk at Hambros and head of risk at UFJI.

Richard Graham, head of institutional business, Baring Asset Management
Graham is head of Institutional Business, which includes responsibility for LDI solutions for UK pension funds.

Richard Warne, head of UK institutional business development, Morley Fund Management
Warne is responsible for developing Morley’s business with institutional investors in the UK and for managing the relationships with investment consultants. He previously worked at JPMorgan Chase for 17 years.


WESBROOM: Twenty years ago risk was rarely mentioned; now it is almost impossible to have an investment conversation without mentioning it. Has the pendulum swung too far, and have we forgotten about return?

BEST: Return is not a forgotten word or concept, nor is it true that risk was not considered 20 years ago: it is simply that there is a greater awareness of risk and a more analytical approach to investing now than 20 years ago. Fund managers have always inherently balanced risk and return and this remains true today.
Has the pendulum swung too far? Certainly not. The relationship between risk and return is better understood now than 20 years ago, when it was possible to find individuals who thought they could produce risk-free returns. Today there is a better awareness that risk and return are two sides of the same coin. To put it another way, if you want more return then you will generally have to take more risk.
Although the discussion and quantification of risk has come a long way there is still further to go, especially in the buy-side of the industry. The sell-side focuses more on stress testing as the critical risk control and measurement tool set, whereas the buy-side remains focused on statistical measures, such as tracking error.

GRAHAM: Yes, there has been too much focus on taking risk out of portfolios over the last 18 months.
This happened because bond yields were compressed, scheme liabilities rose on paper, and the government and the accountant got frightened about funding gaps. And the result was that too much money was encouraged into bonds at the wrong time from an investment perspective, which also locked pension schemes into low returns.
However those who reduced equities in the spring of this year into more diversified portfolios which still offer investment growth have been more successful at managing their volatility.
In general, a useful approach has been to separate assets into those which are liability matching (recognising this can never be exact) and those that have growth, which is the only real way to close the pensions gap. In this context, we believe multi-asset investing has a role to play in helping pension schemes achieve positive real (i.e. net of inflation) returns within an agreed risk framework.

WARNE: No, the pendulum has not swung too far. An appreciation of the connection between risk and reward (or return) remains as critical for the institutional investor today as in the past. Modern portfolio theory as discussed by Harry Markowitz in the 1950s highlighted the need to understand this connection and the desire of the rational investor to avoid unnecessary risk.
The advent of the 21st century, however, has seen pension funds rethink their risk-return strategies, in the wake of volatility, modest return strategies and regulatory change. This has coincided with a sustained period of low bond yields, and an increasing array of alternative assets.
The confluence of these events has made the task of both trustees and their professional advisors more complex, which may create a perception that discussions focus on risk.


WESBROOM: Does the recent market volatility represent noise that should be ignored, or an opportunity to take risk off the table?
BEST: Whether short-term volatility represents an opportunity is a moot point and the answer depends on the investment style of a given fund. Large funds will, in any case, find it hard to “flatten their books” at the speed required to take advantage of short-term movements.
Short-term volatility presents opportunities to hedge funds and other funds where market timing is an integral part of their strategy.
For more traditional funds the longer term economic outlook is more important and they are likely to largely ignore short term volatility and will be more likely to simply tweak their exposures to conform to their view of short term winners and losers from market volatility.

GRAHAM: No, it does not represent noise that should be ignored. Increased volatility, we believe, is here to stay, relative to the extraordinarily benign period of 1980-2000, and schemes need to focus on what this means.
We think the likely implications are: more years of negative returns for equities; more negative correlation of asset performance; greater emphasis on asset allocation and diversity; lower expectations of absolute returns; and more interest in absolute return targets.

WARNE: Periods of volatility are always unnerving for investors, but for longer term investors like pension funds, they should not necessarily represent appropriate moments to make fundamental changes in investment objectives.
Some investors, however, that chased greater returns in the low yield environment of recent times appear to have been inadequately rewarded for risks taken, and the move to wider credit spreads reflects a readjustment (perhaps over-adjustment in the short term) to this equation. Understanding a risk is the first step in managing that risk.
Diversified investing that is designed to reduce the risk of portfolios is not a new theory and diversification remains the goal for prudent investors. As investors reflect on recent events, they should be reminded of these basic principles and look to manage the risk-return equation.

WESBROOM: How should judgement on the timing of risk-reduction strategies be exercised, and by whom?

BEST: As noted above, the timing of risk reduction strategies is largely driven by the nature and investment rationale of the fund.

GRAHAM: Market timing is a difficult game. Napoleon, a great strategist, got the timing of his invasion of Russia badly wrong.
Most corporate backers of defined benefit schemes, trustees, and consultants want to show they are pursuing less risk in their investment strategy. The consultant will recommend, the corporate will encourage, and the trustees will expect the fund manager to deliver.
The solution we offer with a multi-asset portfolio is to seek equity like returns with less than equity risk. These portfolios benefit from a wide opportunity set and flexible guidelines. This allows us the opportunity to increase exposure to growth markets when they perform and to pursue more defensive strategies in weaker markets.
Typically these might include holding cash, structured products, futures and the ultimate insurance of options, to preserve and protect the absolute value of scheme assets for future pensioners.

WARNE: Pension funds and other long-term investors need professional advice to manage the increasingly complex options for investors.
Given that risk and reward are connected it is important that these are managed in tandem, just as pension funds increasingly look to how to fund their future liabilities, not just how investment returns compare to a universe of investment returns. These trends have lead to options being offered by asset managers that look to forecast expected sustainable returns, for a given set of risks.
So called absolute return funds, funds using tactical allocation or diversified strategies funds offer the investor the opportunity of professional asset allocation across a range of investment options that contain a mixture of uncorrelated assets with the aim of balancing optimal risk and return strategies, often for a targeted return linked to interest rates.
What distinguishes these funds from traditional balanced funds is the range of investment options and the sophistication of the allocation process. Those asset managers that have experience of allocating assets on large portfolios are well placed to offer such products and diversified strategies funds give even relatively smaller funds the opportunity to participate in this approach.
Such approaches do need to be adopted in the context of understanding the picture of future liabilities and the implications on future contribution levels and so pension funds advisors have an important role to play in this process.