How to approach risk in an uncertain environment

Meanwhile, economies are starting to look brighter. For the first time in a number of years, there may be synchronous positive growth from the world’s leading economic engines (China, the U.S., Japan and Europe); the political circuses in Europe and the U.S. have abated for the time being; and central banks continue to provide significant support for economies.

However, pension plan sponsors still have to deal with the effects of market dislocation from the global financial crisis, which continue on a number of fronts. Capital market return assumptions are low, yet return requirements remain high in order to close plan funding gaps and/or maintain funded ratios. Return expectations are lower across asset classes because interest rates are low. And underlying structural issues that raise questions about the strength and resilience of even the largest and most prosperous economies have yet to be resolved, creating a backdrop of volatility as markets switch between greed and fear on any hint of good or bad news.

Since the early 1990s, the Federal Reserve Bank of Philadelphia has conducted a survey of professional forecasters, asking what they believe a traditional portfolio (60% equity, 40% bonds) could achieve in the coming 10 years. In 1992, the forecast was an 8.7% annualized return. Today, that 10-year annualized forward-looking forecast is 5.2%. This is a significant drop for plans whose benefit funding return requirements have not moved in a similar fashion.

The financial crisis brought home a new reality to investors: what worked in the past is no longer the best way to run portfolios in the future. Pension investors now have a fuller appreciation of their true risk tolerance, yet they realize that they may have to take on more risk than they’re comfortable with in order to meet their return objectives. So how can they make sure they’re taking these risks with their eyes wide open?

Risk Review
Pension plan investors need to consider portfolio risk from three different viewpoints: how much risk they want to take, how much risk they need to take and how much risk they can actually survive. With low-return estimates for capital markets, the only ways to realistically meet return targets are to move up the risk spectrum and/or to make assets work harder and smarter.

In a challenging low-return environment with a large amount of volatility, intelligent risk-taking requires a change in mindset, portfolio exposures, asset class weighting and portfolio management. With this in mind, here are five recommendations for pension plan sponsors to consider.

1. Change risk mentality and realign the portfolio with the plan’s goals. Somewhere along the way, the investment community lost focus: tracking error and excess return became the main goal of investors and pension committees. The crisis quickly taught pension investors that being down 25% in a down 26% market was not the outcome they wanted.

Excess return or tracking errors tend to be poor proxies for the plan’s ultimate objective. Assets should be aligned with what the plan is trying to achieve and take into account its real required outcomes. Rather than defining success in terms of tracking error or excess return, plans need to realign portfolios with real return and total risk goals that align with their mission, or create specific liability-matching portfolios that focus on the final outcome.

2. Change risk exposures. Traditional asset classes have low-return expectations, and a 60% equities/40% bonds mix will not provide the necessary returns or diversification. Home-country biases have proven to be suboptimal, yet these biases remain in many pension portfolios because what’s familiar is what’s most comfortable.

For real diversification, plans should consider shifting or increasing their exposure to diversifying assets such as infrastructure, futures-/options-based volatility management strategies and foreign equity. At the same time, less-familiar sources—such as emerging market debt or frontier market equity—can potentially provide needed returns in a low-expectation world.

3. Manage risk holistically. Focusing on excess return at the asset class level has also caused the investment community to focus on managing each asset class in isolation (e.g., this is the best Canadian equity portfolio; this is the best core bond portfolio, etc.). While each “slice” was optimally constructed to meet its goal of beating the Canadian equity or bond index, the total portfolio focus became a fallout of several individual optimizations rather than one at the total portfolio level.

Portfolios need to be managed from a total plan perspective, taking into account both cross-strategy risk and the devastating impact of low-probability tail risk events and how they affect the likelihood of meeting portfolio goals. This means using risk management and hedging techniques across asset classes, rather than relying on the simple aggregation of outcomes from individual portfolio sleeves.

4. Use active management intelligently. Market returns alone are insufficient for most investors to reach their investment objectives. In a world where 9% returns for equities are forecast, 1.5% excess return seems inconsequential. With domestic equity returns forecast to be 7% over the next 10 years and domestic bond returns forecast to be half of that figure, the 1.5% is suddenly a large proportion of the total return. Every basis point really does count.

Investors have traditionally focused on choosing active or passive—but now they need to choose active and passive. Skilled investors and exploitable opportunities undoubtedly exist, but the challenge is identifying them in advance. Where to be active is an important consideration, but so is when and how.

On the when front, active strategies have cycles, just as economies and markets do. It is possible to invest in a successful strategy but end up with very poor performance, due to poorly timed entry and exit points. Carefully timing and combining active strategies requires a clear understanding of performance cycles and pitfalls.

With regard to how, going passive doesn’t just mean buying standard market index exposures. Smart beta strategies are best described as rules-based investment strategies that are designed to provide exposure to market segments, factors or concepts. The first representation of smart beta was the creation of growth and value indexes, but, more recently, more complex vehicles such as low-volatility equity have been developed. These smart beta strategies can be combined to create a custom passive completion portfolio, which, when applied in combination with an existing total portfolio, can provide a more precise method for managing total portfolio risk and return.

5. Assess risk management daily. With high market volatility driven by unsettled economic and political times—and the unprecedented speed with which new information affects market prices—opportunities are fleeting, and risks are everywhere. Portfolios need to be nimble through shorter idea-to-implementation time lags, allowing for proactive risk management in real time rather than reactively after each quarter.

If recent markets have taught investors anything, it’s that small exposures can result in outsized returns—or outsized risks. By seeking to track and control the magnitude and direction of these exposures, pension plans can reduce volatility and better focus their portfolios.

Pension investors should replace blunt equity/fixed income trade-offs with a forward-looking solution. An intelligent risk-taking strategy involves integrated, purposeful and continuous management of the total portfolio, targeting total objectives, managing aggregate risk exposures and using a rich tool kit of investment capabilities.

Rob Balkema is portfolio manager, multi-asset solutions, and Tom Lappalainen is director, strategic advice, with Russell Investments Canada Ltd. rbalkema@russell.com; tlappalainen@russell.com

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