Sponsors of DB pension plans continue to face the same old struggle: managing risk. That was the main theme of the DB track at Benefits Canada’s 2011 Benefits & Pension Summit.
DB experts examined risk in detail and also provided attendees with perspectives on investment strategies relating to currency management and emerging and frontier markets.
According to Dr. Damian Handzy, chair and CEO of Investor Analytics, there are two ways to look at risk: in terms of relative measures and absolute measures. Relative measures of risk, such as beta (a measure of a stock’s volatility compared to the overall market) and tracking error (a measure of how closely a portfolio follows the index to which it is benchmarked) are good if investors are worried about matching the benchmark, he explained, but not so good if they’re worried about losing money.
Handzy used the example of tracking error. “This makes a lot of sense if your primary risk is associated with your investors having purchased a fund that promises to track a specific index, but this doesn’t make sense if you’re trying to limit your downside.” Instead, Handzy maintained that investors should be looking at absolute measures of risk, such as VaR (or value at risk, a measure of the risk of loss on a specific portfolio of assets), correlation and stresses, which are better measures if investors are concerned about losing money.
Risk also comes into play when using leverage to improve a pension plan’s asset/liability matching. Calvin Jordan, CEO of the Nova Scotia Association of Health Organizations (NSAHO) Pension Plan, discussed this strategy.
The NSAHO Pension Plan uses leverage to reduce its uncompensated policy risk by hedging interest rate and inflation rate risks that are in DB liabilities. Jordan explained that the NSAHO’s strategy uses unfunded derivative instruments to leverage additional bond exposure beyond what would be possible if the plan used only physical assets.
The NSAHO also uses portable alpha. As an example, the exposure to large cap U.S. equities comes from an unfunded derivative instrument. The NSAHO uses the cash that is left unused to invest in hedge funds that are selected to have reasonably low equity beta. The alpha is the hedge fund return less the financing cost that is inherent in the derivatives. Jordan argued that even if you assume a fairly low hedge fund return, with today’s low financing costs, plans may improve their expected compensation from their active risk budget.
Jordan acknowledged that the hedge funds could provide negative returns, but he compared this risk to the chance that an active manager would provide negative alpha. It’s a risk, but the potential impact on the total fund is minimal relative to a fund’s policy or beta risks, he argued.
Jordan noted that these investment strategies can also create new risks: liquidity, headline and counterparty risks. “These are risks,” he said, “but they’re risks that can be managed.”
A Global View
While risk is one of the DB world’s biggest worries, there was also a brighter side to the DB track. Ian Toner, director, research and communications, with Russell Investments, introduced DB plan sponsors to a new way of thinking about currency management called “conscious currency.” This means “don’t sleepwalk” through currency management, he explained.
Toner said it’s best to pick a benchmark that describes currency in its own terms—not one that’s based on equity exposure or on the fixed income market—then decide how much exposure you want to that benchmark and use the portfolio management processes that you use today. “Use [currency] almost as though it were an asset class,” he explained.
DB plan sponsors in attendance also got a primer on the benefits and pitfalls of global equity investing. Gerald Smith, chief investment officer of Baillie Gifford, spoke to the positives that this strategy can provide but was quick to point out that investors on this side of the Atlantic have a limited capability to choose potential global stock winners. Some of the reasons include a general industry focus on the short term and a misunderstanding of risk.
Investors also don’t recognize the growth potential of these stocks, Smith said. They tend to think that if a company has performed poorly for the last five years, it will do poorly for the next five and that if it’s been doing well, it will continue to do well. “We have a tendency to extrapolate the recent past rather than actually getting under the real skin of the investment.” These factors, according to Smith, tend to push investors away from the principles that make global equity investing successful over the long run.
Global equity investing also includes emerging markets. Pensions can’t afford not to have a view on emerging markets, according to Paul Kapsos, portfolio manager, emerging markets, with the Ontario Teachers’ Pension Plan, because the long-term risk/return trade-off for emerging market equities has been positive.
And that trade-off is expected to continue. Kapsos said the outlook for emerging markets this year is “moderately positive,” while economic growth in the largest economies is decelerating. He offered some other factors to consider: there is an ongoing trend of lower volatility growth/inflation; emerging markets still have a better risk/return premium even when returns are lower; and security selection is becoming more relevant.
Frontier markets (e.g., Uganda or Botswana) are a subset of very small emerging markets, and they are also on the rise. Carl Otto, chair of Cordiant Capital, offered some statistics on frontier markets. While these markets have lower market capitalization and less liquidity than more developed emerging markets, they represented 17 of 20 of the fastest-growing economies in terms of average annual GDP growth from 2000 to 2009. Frontier markets account for 22% of the world’s population and 7% of global GDP, yet they account for only 3% of the world’s market capitalization. Compare this to emerging markets, with 63% of the world’s population, 42% of global GDP and 42% of the world’s market capitalization.
DB plan investors should ensure that their frontier market portfolios consist of consumer staples, food, drink, pharma, manufacturing, telecom and financials, said Otto. There should be little or no exposure to natural resources, he warned, because in some frontier market countries, the state has a “heavy hand” in that sector through nationalization or excessive taxation.
In addition, he noted, DB plans shouldn’t restrict their emerging market and frontier market exposure simply to private and public equity funds. They should also include floating rate loans with an emphasis on infrastructure debt, as these loans are good protection against inflation.
Otto said that investors planning long-term asset allocation should not forget that by 2030, the developing world’s middle class will equal today’s combined population of Europe, Japan and North America.
He also reminded the audience that frontier markets remain overlooked and misunderstood by most investors. “As some emerging markets will be moving into the developed market category, so will some frontier markets move into the emerging market category.”
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