Market volatility creates both challenges and opportunities for plan sponsors, money managers and custodians.
The bad news dominating international media over the past few months paints a picture of an institutional investment marketplace under siege. The domino effect of the subprime mortgage disaster, the credit crunch and the global financial crisis have pounded securities markets and resulted in substantial losses for pension funds, creating tough times for plan sponsors, money managers and custodians. How each of these industry players has reacted to the volatility illustrates the unique advantages and constraints of their roles. While the bottom of the current downturn has yet to be identified, lessons are already being drawn in preparation for the next episode.
Adapting to the New Environment
Perry Teperson, vice-president of Leith Wheeler Investment Counsel, explains that the current market volatility is affecting all investors, be they institutional or individual. This volatility, in turn, has ramifications for him. “Our business has been indirectly impacted as we, like all money managers, see our revenues declining as assets under management drop,” he says. “It’s been painful for everybody.”
Teperson explains that while there’s been no change in the company’s business practices, the investment criteria used by Leith Wheeler managers have adapted to the times. “We have a disciplined investment process that hasn’t changed in 25 years,” he says. “However, in terms of the building of portfolios, we’ve kept a keen eye on risk. We’ve been adding to names that we feel are a bit more defensive and not adding to the parts of the portfolio that are less defensive.” While Leith Wheeler is strictly a value shop, Teperson points out that all portfolios, value or growth, are down significantly. “We’re just talking about different degrees of negative.”
For Marc Poupart, director of pension and retirement programs with Hudson’s Bay Company (HBC), the administration of the company’s defined benefit (DB) and defined contribution (DC) plans has not been significantly affected. However, while the DB plan is currently in surplus, Poupart is concerned that its funded status is deteriorating. “From an accounting point of view, a big swing like this might create a lot of volatility in the coming years as you amortize the increase in liabilities,” he says. “While it’s not a direct cash hit, it does have some implications when you’re providing information to your lenders.”
For the DC plan, the main issue for HBC centres on the company’s communications strategy with members who are concerned about their savings. The company mulled over the idea of a comprehensive communications effort to allay members’ fears but decided to hold off when it was suggested that a message of reassurance might achieve the opposite of the intended effect. “Everyone has seen the market downturn,” he explains. “We felt that such a communiqué might create more concern than anything else.”
Reaching Out
Poupart describes the company’s communications strategy as more reactive than proactive, adding that no communication has been the right communication at this stage. Instead, HBC is focusing on the issue of consistency and the message that the markets will rebound eventually. The company leaves communications with individual members to its recordkeeper. Poupart says that, to date, the majority of members are calling to ensure that their funds haven’t been depleted.
Teperson has also seen a marked increase in communications traffic with his clients. “We’ve noticed an increase in calls from clients between meetings—even shortly after a meeting—to get updates because things have moved so quickly in the markets in the last few months,” he says. “People are understandably concerned about their financial results.” Leith Wheeler has engaged in a comprehensive communications campaign that puts the investment managers in touch with clients more than usual in an effort to appease concerns over fund values.
“We’ve written some special pieces, and we’ve made a concerted effort to keep in touch with all of our clients by phone if they’re not local,” he explains. “We’ve also made an effort to step up the human contact a little bit more than usual, so the frequency of contact is increased.”
Opportunity Knocks
As money managers and plan sponsors have been forced to make adjustments to aspects of their businesses, so have custodians, which are also not immune to the whims of the current market. As a significant proportion of their revenues is tied to market valuations, custodians are facing the combined prospects of decreased asset values and constrained securities lending, both of which eat away at the bottom line. For companies with vision, however, there are opportunities to be found in the current dire market environment.
Stephen Smit, president of State Street Canada, suggests that the failure of a number of significant players in the financial services industry has created demand for a host of risk, compliance and analytic services. “At the moment, we’re more focused on the short term than we normally would be, but the current situation is creating enormous opportunities for us,” he says. “The asset management industry is particularly challenged right now and is looking for ways to manage its costs, which provides an opportunity for us to ask if there are other products or services we could be selling.”
Smit explains that when clients are feeling pain, they are more amenable to suggestions for creative ways to increase efficiency and relieve the pressure from the combination of rising costs and diminishing returns. In this environment, State Street is reaching out to prospective and established clients to offer its services in areas such as enhancing investment performance, risk and cost management and gathering assets. “As companies look at their internal activities, there’s probably a heightened tendency to focus on those activities that they consider core to their businesses, which leads to a greater willingness to outsource activities that aren’t considered core,” says Smit.
The recent volatility has prepared State Street to better anticipate client needs during periods of market turmoil, he explains, and has provided lessons on asset allocation, portfolio construction and the “myth” of diversification. “It has also taught us that what we do is provide more than custody, administration and accounting services,” he says. “We have a diversified set of businesses and, while our core asset servicing business has been under strain during the recent volatility, other lines of business, such as our investment research and trading and securities lending divisions, have done extremely well.”
State Street isn’t the only industry player that sees a silver lining in the current situation. According to Damon Williams, head of institutional portfolio management at Phillips, Hager & North, the securities market is rife with fire-sale opportunities for investors with the stomachs to handle the short-term twists and turns. “One of the areas in which we see the most upside has been corporate bonds, particularly in the financial area,” he says. “When you look at the level of credit spreads now compared to the past, it exceeds anything else current investors would have seen in their careers.”
Live and Learn
Better risk management tools may result from the current crisis, explains Williams, as it will serve as a key stress test, and the lessons learned will position the industry to better deal with extreme events such as these in the future. Better educated investors are also appearing as the dust settles, he says, which is evident in the increased frequency and depth of questions from clients regarding the markets and how they relate to their investments. “There is a great need from clients for information, as they are very interested—and understandably so—in what’s going on in the markets and in their portfolios,” says Williams. “We’re seeing much more detailed questions about their holdings and our strategies than we did a couple of years ago.”
Teperson suggests that the main lesson that should be gleaned from the current market environment is that the worst-case scenario is not only possible but also should be planned for. He echoes Smit’s thoughts on diversification, pointing out that even corporate and government bond markets—which, in the past, have not had significant risk of default—have declined in price substantially. “I think the lesson is that during times of severe stress, even your worst-case scenarios for corporate bond prices could be reached and exceeded,” he says. “Just because it hasn’t happened in the last 25 or 30 years, it doesn’t mean it couldn’t happen today. It’s probably a good idea to plan for such a scenario even though it’s an extremely unlikely event.”
Teperson believes that the global financial crisis will change people’s opinions going forward as to what risk management scenarios should be debated, discussed and planned for. When you live through an experience like this, he explains, it is useful in terms of preparing for the next downturn.
For Poupart, the lesson to be learned is a familiar refrain: stay the course. “As fiduciaries, we’re doing things that influence member behaviour,” he says. While the company is avoiding any sudden changes, it is reconsidering its philosophy regarding where to invest some of the alternative investments in its DB plan, which are mostly real estate and private equity investments. “I suspect that some plan sponsors that have been heavily into alternatives such as hedge funds are reconsidering their decision,” he says.
What plan sponsors should keep an eye on, explains Poupart, is the behaviour of their fund managers, which should remain consistent regardless of the markets. “We go back to what we expect of the growth and value managers and don’t get overly concerned if their style drifts a bit,” he explains. “However, if we hired them for a mandate, we want to make sure they continue that. And if they change, we want to understand why.”
On the other side of the equation, Teperson says that dealing with clients— either institutional or private—during times like this often requires a discussion on risk and investment objectives, as there can be pressure to make changes in order to stem losses or exit certain strategies altogether. During these times, he explains, it pays to be consistent and patient. “It’s really long before a market downturn that a client should be thinking about volatility,” he says. “It’s a bit late in the day to be discussing reducing your risk or gearing up for volatility when you’ve had a significant market downturn already. The time to plan for it is before it happens.”
One issue on the minds of custodians is the future of securities lending, which has reportedly dropped in popularity globally after a Watson Wyatt report in November warned fund managers about specific risks relating to the practice. Smit says that, to date, State Street’s securities lending program has seen a small drop in assets on loan, stripping out what would be the market decline. Roughly 10% of the company’s customers have exited or pulled back from securities lending, but he believes this is temporary.
“Regulation is possible if not probable, but there’s an abundance of academic and practitioner evidence that securities lending enhances the efficiency of markets,” he says. “So, in that sense, I don’t think securities lending is going to go away.” However, he adds that additional regulation regarding disclosure and reporting is likely to come out of this economic crisis.
Smit admits that certain areas of his business have suffered, but says that the new possibilities on offer have more than outweighed the losses. That’s where the company is currently focused. “The idea of volatility creating opportunity can’t be stressed enough.”
Jody White is associate editor of Benefitscanada.com.
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the January 2009 edition of BENEFITS CANADA magazine.