I lost count over the latter half of 2007 how many times I was asked to comment on the subprime meltdown and the ABCP credit crunch. I remained unusually tight-lipped for a consultant, as I was convinced that any insights I could offer at 9 am would be wrong by noon. It turned out that my spider sense was right, as we watched many of the world’s largest, most sophisticated banks and investors announce their exposures and resulting writedowns.
I remain a bit at odds with the deal in principle announced in December by the pan-Canadian Investors Committee for Third-Party Structured Asset Backed Commercial Paper, chaired by lawyer Purdy Crawford. His statement: “This proposal respects the principles we established for the restructuring—fairness and equity for all investors, value preservation and market transparency of the underlying assets to promote liquidity and market confidence in new notes to be issued as part of the restructuring” has done little to change my impression that the markets will continue to be the product of investor crowd psychology. Investor crowd psychology follows two trends: greed and fear. We are now experiencing the market impact resulting from the greed cycle, and by all accounts, we appear to be entering the fear cycle.
As a consultant, my role is to help pension programs pay their pensions. One of the greatest challenges in trying to fulfill this role is communicating with pension funds that swinging for the fences is not a good investment strategy. This task can become even more challenging when market and manager returns are stronger than historical averages. Under these circumstances, the lure of doubling down on 11 is sometimes stronger than the less exciting process of rebalancing the portfolio to its policy allocation in respect of equities, bonds and alternatives. Rebalancing is a fundamental risk management process that many but not all pension funds can systematically employ in their programs. Inherent in a rebalancing program is that you are prepared to sacrifice some upside return in order to help the fund lessen its downside return.
The basis for a rebalancing program is the policy portfolio or the strategic allocation that the pension fund has to equities, bonds and alternatives. Developing a diversified investment structure relies on a clear understanding of the pension fund’s risk and return tolerances and requirements. This is facilitated through asset-liability modeling studies that will outline asset allocations of varying expected risk and return. This is often referred to as risk budgeting. This type of risk-return management tool is well established and is based largely on the long-term history of asset class returns and their volatility patterns. In addition, an analysis is performed on how the asset classes to be modeled, correlate or diversify with each other. Important in this process is communication between the sponsor, investment manager and consultant to determine portfolio solutions that are most suitable to meet the risk-return budget of the pension fund.
The development of a policy portfolio relies heavily on historical information. In order to give the process some forward thinking views, we suggest factoring in the risks of investing in an environment that seems to be increasingly less transparent. When you hear the term ”transparency risk,” intuitively, you probably think about hedge funds or the information risk associated with private equity investing. We believe that transparency risk applies to both traditional and alternative asset classes.
Plan sponsors need to understand that many public companies that issue traditional equities and bonds are becoming extremely complex to research and understand. To help illustrate, consider a Canadian bank that is a candidate in a pension fund’s Canadian equity portfolio. The bank’s operations include proprietary and agency trading, underwriting bond and equity issues, participating in structured finance deals, running hedge funds; to name a few. On top of it all, the bank has a risk management team dedicated to hedging company specific risks that are inherent in these operations. While the banks are required to disclose their aggregate hedged positions they are not about to freely disclose the names of the counterparties taking the other side of the hedges.
This represents a rather significant transparency risk that will need to be considered by the pension fund’s Canadian equity and bond managers. The consultant’s challenge is to quantify and qualify this additional risk factor into the risk budgeting process in terms of how Canadian equities will correlate against other asset classes going forward versus historical results. This is a particularly important analysis for pension funds that are considering exposure to alternative asset classes such as hedge funds as the amount of transparency risk can be compounded in the portfolio.
Markets are nothing more then the manifestation and evolution of crowd psychology. For a pension fund’s investment program to deal with markets, good and bad, emphasizing the fundamentals like rebalancing works. Swinging for the fences or doubling down on 11 are not good pension fund investment strategies. Build on the fundamentals by enhancing your risk management tools to include the analysis of emerging transparency risks that may be lurking in your pension portfolio. .
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