Rough Ride

The chart below overlays the performance of the S&P 500 index onto the Chicago Board Options Exchange Volatility Index (VIX)—otherwise known as the “fear index.” The VIX represents a measure of the market’s expectation of volatility over the next 30-day period. Over the last 10 years, the peaks of volatility have generally corresponded with a relative weakness in stock prices. These lower stock prices have translated into good buying opportunities before subsequent market advances. In fact, many professional investment managers believe that periods like the one we are in now give them an opportunity to demonstrate their superior stock-picking skills. The only issue is the timing and length of the turnaround. Note, also, that although the VIX is currently at a five-year high, it is still well below the volatility peaks of the technology bubble in the early years of this decade.

Recognizing that periods of higher volatility are a fact of life, one of the best ways to deal with them is to revisit the basic principles of investing and risk management. Of course, how these principles are best applied depends on the unique circumstances of each plan, but here are some general guidelines for pension investors.

1: Develop an Appropriate Long-term Asset Allocation Policy

While the stock market losses experienced in recent months are disappointing, they are certainly within the realm of what can be expected, given the well-documented historical market risks. For this reason, asset allocation strategies for pension and other institutional portfolios should take into account the sponsor’s risk tolerance for periods of expected market weakness. While it may be little comfort when your portfolio value is declining, at least you know that your strategy encompasses this possibility.

More recently, experts within the pension and investment community have focused on liability driven investing (LDI) and its potential benefits. Based on fair value principles, LDI incorporates market-based valuations of assets and liabilities, so that true economic values are reflected on both sides of the pension balance sheet. This provides an explicit evaluation of the mismatch risk faced by the fund (i.e., the variability of excess return or the difference between the return on assets and the growth of plan liabilities). Controlling the mismatch risk can be a powerful tool for managing the risk of pension underfunding.

2: Diversify

Diversification is the most fundamental concept of long-term risk management and is based on the premise that different investments will perform differently throughout various stages of the business cycle. A portfolio consisting of a variety of investments will, on average, yield higher returns over the long term and exhibit lower risk than any individual investment within the portfolio. The key to diversification is to combine investments that are not perfectly correlated, so that the outperformance of some investments will help neutralize the underperformance of others.

Investment policy development aims to create a diversified asset allocation strategy appropriate to the unique circumstances of the plan. But diversification is also important on a number of other levels.

Within an asset class – Today’s investment markets offer a range of choice that simply wasn’t available a few years ago. The Canadian fixed income market is a case in point. As it has become more difficult to add value in this asset class with any consistency, managers have been busy expanding their tool boxes. New instruments and strategies (used with varying degrees of success) include an increased focus on corporate credit analysis and the use of foreign pay bonds, real return bonds, mortgage-backed securities and higher-yielding debt issues.

Looking at equities, more attention has been directed toward segments of the markets where inefficiencies may be exploited and good research can translate into added value. These include small and micro cap stocks, as well as emerging market economies such as the new giants, Brazil, Russia, India and China. Some fiduciaries may ask why they should consider investing in these risky areas. The answer is that they tend to be under-researched relative to more the developed markets, they may have strong long-term growth potential ahead of them, and the economic factors affecting, say, a manufacturing company in India are very different from those affecting a Canadian bank.

Across geographic regions – In an increasingly globalized economy, it’s becoming more difficult to make the argument that investing across a variety of regions and countries will minimize risk. We have only to observe the impact of the “Made in the U.S.A.” credit crisis on the stock markets of the developed world to see that simple regional diversification is becoming less effective as a risk management tool. Nevertheless, over the long term, markets do behave differently and are influenced by local as well as global factors. As Canadian investors, we also have to recognize that the Canadian stock market is highly concentrated in the financial, energy and material sectors, which account for about 75% of the market capitalization of the S&P/TSX Composite Index. In fact, only 18 stocks make up nearly 50% of the index. The narrowness of our market has been beneficial for performance over the last several years, as these sectors have been strong performers. But we only have to look as far back as Nortel Networks earlier this decade to understand the risk associated with market concentration.

By investment manager and style – Naturally, all investment managers will have periods in which their performance is weak relative to other periods and to that of their peers. There are two broad reasons for manager underperformance: manager risk and investment style. In either case, for good managers, these periods should be relatively short and outweighed by the periods of strong performance.

Manager risk includes all of the potential organizational issues that may have an impact on the successful management of an investment portfolio, such as the loss of key personnel and firm instability, as well as a failure of the manager’s investment process to achieve success. Combining multiple managers in a portfolio helps to minimize manager risk.

Equity investment style refers to the characteristics that a manager considers when building a portfolio of stocks. Although equity strategies have evolved, the industry still tends to rely on the growth and value style categorizations, and there continue to be periods where performance is significantly differentiated by investment style. Much of the current decade has favoured value managers. Since late 2006, however, growth managers have generally performed better than their value counterparts. The outperformance of growth managers in 2007 has been substantial in U.S. and international markets. Diversification through allocation to multiple investment styles is therefore an important risk control.

Through alternative strategies and asset classes – The diversification benefits of alternative strategies and asset classes, such as real estate, hedge funds, short-selling, private equity and infrastructure, have been well documented. Many alternative strategies are expected to have attractive low-correlation characteristics when introduced into a portfolio of stocks and bonds. Once the exclusive realm of large portfolios, alternatives are now finding their way into smaller funds as well. However, it is absolutely necessary to have specific goals, understand the nature and magnitude of the risk associated with the investment, and have a clear grasp of the expected risk management benefit to the overall portfolio.

3: Rebalance Your Assets

Part of developing an asset allocation strategy for a pension portfolio includes determining whether or not tactical asset mix shifts will be permitted as a potential source of additional return. If active asset mix management around a long-term asset allocation target is permitted, the manager responsible for asset mix management will apply its outlook for markets to the portfolio construction process. Managers will attempt to adjust the portfolio asset mix to take advantage of an expected turnaround in the stock market (i.e., buy low and sell high).

Alternatively, many pension portfolios use a process of systematic asset mix rebalancing. This is especially popular with plans that use a specialty investment management structure. As the performance of the markets—and in turn, the different components of the portfolio—move the overall asset allocation off the desired long-term target, a rebalancing mechanism is triggered to bring the asset mix back in line with the target.

In the absence of active asset mix management, rebalancing can modestly increase returns and significantly reduce volatility risk compared to a simple buy-and-hold strategy, which lets relative asset class performance dictate what the asset mix will be at any given time. In a 2003 study by Eckler Ltd. analyzing a 50/50 portfolio of Canadian stocks and bonds (passively managed to the applicable benchmark indexes), a hypothetical portfolio that employed systematic quarterly rebalancing outperformed by about 50 basis points per year over the 10 years ending on Dec. 31, 2002. More importantly, the annualized volatility was about 125 basis points lower for the rebalanced portfolio. The study noted advantages for the rebalanced portfolio over shorter periods as well. One significant benefit was that rebalancing forced the sale of equities throughout the run-up in technology stocks in 1999-2000, thereby reducing exposure when the tech bubble burst.

Rebalancing costs may be minimized, depending on the frequency with which the rebalancing is triggered and whether or not the regular plan cash flows can be used as a rebalancing tool.

4: Establish a Risk Budget

Much has been written about risk budgeting for pension plans. Risk budgeting is based on the assumption that risk cannot be eliminated; it can only be minimized and managed. The goal, therefore, is to create and manage an investment strategy within a desired risk framework. Plan fiduciaries sensitive to market volatility and other risks associated with investing in capital markets are strongly encouraged to investigate the merits of establishing a risk budget.

Once the risk budget is determined, plan fiduciaries monitor portfolio performance to ensure that risk exposures do not differ excessively from those specified in the risk budget. Fiduciaries are advised to monitor performance on a monthly or quarterly basis, even though the horizon for risk is normally measured in years.

Risk-budgeting strategies should include a risk-rebalancing mechanism. In other words, if you are monitoring risk on a continual basis at a reasonable frequency, as the equity markets to which your portfolio is exposed exhibit greater and greater volatility, part of the strategy will be to adjust or rebalance the portfolio back to within the range of acceptable risk or volatility (analogous to rebalancing the asset mix).

Risk rebalancing must be accomplished within the constraints of a long-term asset allocation and asset mix rebalancing strategy. Different asset classes, investment strategies and styles, and managers all have varying risk characteristics. Some will exhibit significantly lower volatility than others, and your risk rebalancing strategy may include overweighting these components of the portfolio in times of greater market volatility.

5: Measure and Manage Your Risk Exposure It is unnecessary and unwise to carry this concept to the extreme and examine the impact of daily market gyrations on your pension portfolio. However, quarterly—or even monthly—monitoring is important when risks are magnified.

There are a number of ways to monitor risk. Simply calculated risk metrics, such as standard deviation, information ratios, Sharpe ratios, downside market capture and other risk-adjusted measures of performance, can be leading indicators of upswings in risk when applied over time. More sophisticated approaches, such as value at risk and portfolio stress testing, can provide meaningful information on the magnitude of potential portfolio losses and the possible impact on the plan’s funded status over various periods.

Defined benefit plan fiduciaries need to monitor investment results against plan funding policies. Do the current market realities, the financial status of the plan or the financial strength of the sponsoring organization warrant changes in the funding policy or the budgeting process? Risk auditing involves periodically evaluating all of the main risk exposures of a fund, and assessing the impact on recent and prospective funded status volatility and contribution requirements. This approach is gaining steam as more plans recognize the need to budget in advance for significant changes in funding, cash costs and pension expense.

6: Stay Invested and Keep Investing

A significant amount of effort and knowledge is required to navigate financial markets successfully. Empirical evidence doesn’t support the concept that the majority of managers can consistently add value through asset mix shifting or market timing. Consider, as well, that during the 1990s, missing just the 10 best-performing days on the S&P 500 would have resulted in cumulative performance being well over 40% lower for the decade (if you also assume that you were invested all 2,500 or so other trading days during that period). In short, trying to judge the top or bottom of a market is tremendously difficult. The easiest way for fiduciaries to navigate volatile markets is to stay the course, stick with thoughtful and diversified long-term strategies and continue regular plan cash flows. Staying invested in weak markets is one of the toughest aspects of investing, but it is crucial to meeting long-term objectives.

There are many historical examples of why staying the course has been the right long-term decision. Since 1900, the S&P 500 has had nearly 400 short-term declines of up to 15%, more than 40 corrections of 15% to 20% and nearly 30 severe corrections or “bear markets” of more than 20%. Each and every time, the markets have rebounded— usually quite strongly. For example, following the one-day drop of 20.5% in the S&P 500 on Oct. 19, 1987, it rebounded 23.2% in the subsequent 12-month period. Sometimes the period of weakness lasts longer before the recovery. Following the long 44% decline in the S&P 500 between March 2000 and October 2002, the markets took just 12 months to rebound by 34%. Clearly, it can be extremely costly for investors who suffered earlier losses to miss the subsequent rally.

7: Don’t Forget to Communicate

In times of increased risk and market volatility, it’s more important than ever to ensure that the lines of communication are open. Committee members and trustees need reassurances that the principles behind their long-term strategies are sound. Fiduciaries need to know the impact of volatility and weak returns. They need to communicate with their managers and advisors to get a full understanding of the current situation and to help them decide if any short-term actions are required. Investment managers need to instill a sense of confidence, communicate where markets are going and show how their portfolios are structured to reflect this outlook. Plan members need to know what impact, if any, all of this will have on their personal pension entitlements.

Periods of higher short-term risk and market weakness are inevitable. But we mustn’t forget that it is exposure to risk that creates the opportunity to generate returns in the first place. Plan fiduciaries trying to maximize returns without maximizing risks have a duty to ensure that the strategies they adopt are appropriate to the long-term objectives, funding risk tolerances and unique nature of their plans. They must also ensure that their strategies evolve along with their plans and financing abilities.

Risk management is no easy undertaking—in fact, it’s an awful lot of work. But for sheer peace of mind, nothing beats a properly crafted and well-maintained risk management strategy based on proven principles.

Greg Malone is a principal and Jason Campbell is an investment consultant in the Toronto office of Eckler Ltd. gmalone@eckler.ca; jcampbell@eckler.ca

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