Top 40 Money Managers Report: In it to win it

A white paper released by OMERS in February says “stock market shocks have occurred more frequently since 2002 with declines by 10% or more on five occasions, including the 33% meltdown due to the 2008 global credit crisis.” As a result, the paper notes, pension plans face a challenge when it comes to recovering lost capital: “a 33% decline on $1 billion in a single year would require a 50% return to get back to $1 billion.”

Many investors get swept up in short-term stock market storms, and some end up overreacting to these events to the detriment of the long-term health of their portfolios. A stressful market environment triggers flight-to-quality pressure (i.e., the pressure to move to the safest possible vehicles), which typically leads to poor performance of riskier assets. As declining bond yields put upward pressure on liability values, it’s the worst of both worlds for a pension plan.

But volatility in equity markets is just the nature of the beast. It will never be zero, says Jean Masson, managing director with TD Asset Management (No. 1 on the Top 40 list). “Market volatility is absolutely here to stay, [for] it’s a mean-reverting process,” he explains. “Some periods will be characterized by high volatility—such as 1999 to 2002 and 2008 to 2009—and some periods will be characterized by subdued volatility levels, such as 1992 to 1996, 2004 to 2007 and 2012 to 2013. But there will always be some degree of volatility.” So how can pension investors manage it?

Tip #1: Don’t Overreact
Masson says paying close attention to short-term volatility is not imprudent, but reacting to such short-term trends could potentially hurt pension plans’ longer-term interests. “Most pension plans have to make an assumption about the level of return they’ll receive over the long term, but short-term volatility can cause returns to deviate from this assumption. Markets can overreact in the short term, so short-term market volatility may lead many investors to overstate—or understate—long-term volatility and risk.”

Terry Kirby, senior vice-president, institutional investment services, with Franklin Templeton Investments (No. 18), agrees. “In an effort to mitigate the effects of a possible black-swan event, plan sponsors are increasingly focused on volatility,” he says. “[But] too much focus on the short term may be problematic, especially if it leads to action that may not be in their long-term interests.”

Those who prefer to look at volatility as an indication of potential riskiness, however, say it’s worth the attention. Michael Hood, global markets strategist with J.P. Morgan Institutional Asset Management (No. 9), says plan sponsors should monitor volatility for two reasons. “First, jumps in volatility sometimes serve as early-warning indicators of fundamental changes in the economic or market landscape,” he explains. “Second, elevated volatility tends to be associated with elevated correlations among asset prices.”

Kirby says that by focusing simply on the effects of volatility, investors miss half the story. “We should also determine the causes of volatility,” he says. “A stock may be considered volatile when it is outperforming on a consistent basis. Many people would likely not mind this type of problem.”

Some causes of volatility can be extremely short-lived—or, perhaps, the result of panic triggered by speculation that a company may be merging with, or being acquired by, another business entity.

Volatility also needs to be considered in terms of return expectations, Kirby adds. “If investors want no volatility, they should just hold cash,” he asserts. “However, the resulting returns are likely to be in conflict with requirements for an adequate retirement.” In other words, holding risk-free assets alone won’t get pension investors to their goals.

Instead, plan sponsors should focus on managing volatility, says Damon Williams, president of Phillips, Hager & North Investment Management (No. 3). “From an investment manager’s point of view, volatility provides an opportunity to make accretive investment decisions that provide value over time.”

Pension investors should make risk budgeting a key part of their investment discipline. This process includes setting risk limits on each asset class based on how much plan volatility the sponsor can tolerate, and then allocating assets in compliance with these limits.

Sponsors that create a risk budget for their portfolios are better equipped to “strike a balance between the amount of volatility they can tolerate and the need to meet their longterm obligations,” says Michael Augustine, vice-president and director with TD Asset Management.

Tip #2: Look on the Bright Side
One positive aspect of volatility is that it can cause significant stock-pricing dislocations—which, in turn, can lead to great opportunities.

“For contrarian or many value investors, stocks that have dropped significantly because they are out of favour due to some short-term circumstance can present a buying opportunity for long-term investors,” Kirby explains. “Likewise, as stocks lose momentum, the ‘hot money’ day traders and hedge funds will look elsewhere rather than analyze the cause of volatility, which creates a significant opportunity for longerterm fundamental managers.”

After all, risk is not a four-letter word as long as it’s compensated, says Janet Rabovsky, director of investment consulting services with Towers Watson. “It is important to understand where risk is being taken and for that risk to translate into outperformance. Active managers need some volatility in order to outperform the market.”

Masson agrees, advising plan sponsors to “consider if they are taking uncompensated risk.” Case in point: between December 1999 and December 2013, the most volatile equities on the S&P/TSX Composite Index underperformed less-volatile equities, according to a TD analysis using data from Standard & Poor’s. Those who owned the most volatile stocks, Masson says, were not compensated for the additional volatility.

Tip #3: Focus on the Long Term
It makes sense for both DB and DC sponsors to look at volatility to ensure that their portfolios are tracking to long-term objectives. However, it should not be viewed in a vacuum but as part of a risk/return analysis.

“Plan sponsors generally target a desired level of overall risk in their portfolios, determined by the particular characteristics of the plan,” says Hood. “Allocating this risk budget across assets thus requires the plan to take a view on the expected volatility of each investment and its trade-off against expected returns.”

Many plan sponsors use historically realized volatility as a guide to the future—which is not a bad approach, as long as the data set used covers several market cycles, says Hood. He endorses the technique and favours a forward-looking approach based on his understanding of the likely economic environment in the next 10 to 15 years.

Rabovsky acknowledges that pension plans should typically be long-term investors and arrange their investment strategies accordingly. However, she contends that certain circumstances justify a more short-term approach. “If the DB sponsor is in an industry that is more cyclical or experiencing financial difficulty and its liabilities are mature— or, in the case of DC, if the members are in less-stable industries—these could all be reasons why a more short-term view may also be required,” she says. “A more conservative asset mix usually requires greater contributions in order to meet the same long-term benefit that would be earned by an investor willing to take on more risk.”

Tip #4: Know How to Play the Game
Plan sponsors and money managers can adopt a number of strategies to neutralize or limit the impact of volatility. These strategies may involve increased allocation to bonds or greater cash weights. Another strategy involves specific stock selection that favours buying value stocks. (Due to their lower valuations, these stocks serve as safety valves during market turbulence.) Yet another way is to sidestep volatility through sector diversification: adding more stocks from non-cyclical sectors while minimizing exposure to cyclical sectors.

All things considered, though, risk-taking is intrinsic for success in active management of a portfolio. “You can’t add value without taking risk,” says Williams. “Plan sponsors know this and actively try to structure their fund with the most efficient trade-off between risk and reward.”

Almost every long-term investment strategy is tailored to address investors’ investment objectives while minimizing volatility. Plans that prefer to maintain a healthy allocation to equities are seeking strategies that are more absolute return in nature, Rabovsky explains. “These can be value and quality types of strategies that provide protection in down markets and, therefore, deliver lower-than-index volatility. Over shorter periods, these strategies tend to perform much differently than the index and can be mistakenly thought to be volatile.”

Some investors are seeking low-volatility equity strategies. “As such, these strategies tend to be focused on dividend-paying securities,” says Rabovsky. “The result is some downside protection in negative markets and some [forfeiture] of return in rising markets.”

Investors with a long-term horizon that don’t need current liquidity can choose from various hedge fund strategies, real estate and infrastructure, which can deliver equity-like returns but with lower volatility.

“Income-oriented real estate and infrastructure have become quite popular with pension plan sponsors seeking to reduce the variability of return and, therefore, cash contributions,” notes Rabovsky. “With these two asset classes, approximately 75% of the total return comes from rental payments or contracted cash flows, thus creating greater certainty of return.”

Hood says the role of hedge funds in portfolios has evolved since the days when many plan sponsors thought of them as high-return vehicles. “In practice, hedge funds have delivered more moderate returns but with significantly lower volatility than observed in public markets. As such, hedge funds can serve as a useful portfolio construction tool, giving plan sponsors a source of return that does not consume much of the risk budget.”

Private equity is “an efficient use of risk,” as returns are generally expected to be 300 to 500 basis points higher than public market equities, notes Rabovsky, adding that investors that choose to invest in private equity are willing to accept the illiquidity to achieve a higher return over longer periods.

On the other hand, some money managers are looking at liability-driven investing (LDI), a de-risking approach that’s used to dampen surplus volatility.

“Many of our clients have been moving away from thinking about risk relative to a benchmark and focusing more on risk relative to their obligations,” says Augustine. “[LDI] can help them avoid short-term surprises and provide more stable and predictable outcomes in the long term.”

However, this approach comes at a cost: lower returns. In recent months, though, this reality has been offset by two factors: an increase in base yield levels from record lows and a significant improvement in the average Canadian plan’s funded status.

The appetite for lower volatility strategies has been growing, borne out by the rush of new products across a range of asset classes. According to Rabovsky, in 2006, there were approximately 10 low-volatility equity products available. Now, there are more than 80 in Canada and globally.

Investors can reduce volatility by increasing the proportion of the portfolio invested in bonds relative to equities, but the flip side is often moderate returns, says Rabovsky. So, when playing the markets, it’s just as important for investors to understand why they are trying to reduce volatility—and what they hope to achieve over the long term.

Vikram Barhat is a Toronto-based business and financial journalist.

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