Continued…
Proprietary solutions
Proprietary investment solutions are often single-manager offerings whereby the investment manager and promoter are one in the same. These solutions can be one-dimensional or two-dimensional propositions and can be either actively or passively managed.
Under a one-dimensional scenario, plan member input would be limited to the expected retirement date or expected time horizon; under the two-dimensional scenario, plan member input includes the time horizon and the investor risk profile. In either case, a single-manager proprietary solution is plausible under a scenario whereby plan member needs are focused on low asset size, simplicity, minimal involvement and low cost.
The most effective single-manager solutions are the ones that are managed passively across all asset classes. If a plan sponsor is going to have the same portfolio manager oversee each of its different asset classes, then it makes sense to have each asset class managed passively. Index managers are less costly than active managers to begin with, and they are usually paid on the basis of a declining scale. Therefore, the greater the total asset level, the lower the total cost.
In addition to cost, a single-manager solution is certainly a valid option for plan sponsors that philosophically believe that most active managers are not able to consistently outperform their benchmark index over the long term and that, despite popular belief, active managers are not able to outperform in adverse market conditions. In other words, they believe active managers cannot consistently provide downside market protection over the long term. Plan sponsors choosing this option often don’t have the time or interest to select and monitor active investment managers.
The most important consideration with this option is to ensure that the tracking error relative to the benchmark the manager is trying to replicate is minimized at each individual asset class level. Consequently, assets permitting, the plan sponsor should opt for a full replication strategy or investment process versus one that is based on portfolio optimization or a purely synthetic approach.
Choosing a passive investment approach also prevents the portfolio pitfalls—including the risks of investment manager, investment style, sector overlap and stock redundancy—associated with a single-manager active approach. Unfortunately, though, there may be certain portfolio construction risks that cannot be avoided with this option. These are related to the development and design of strategic asset allocation, portfolio rebalancing, time horizon glide path and investment manager governance.
As far as developing an appropriate strategic asset allocation that is aligned with the investment policy of the plan member universe, this usually requires an extensive retrospective and prospective analysis. The retrospective work involves using optimization methodologies to evaluate past data, and the prospective work involves forecasting interest rates, inflation and equity risk premiums in order to determine how they will impact capital market returns in the future. In both cases, plan sponsors will need to make important assumptions, which will ultimately impact the results. These assumptions, therefore, will be based on the particular views and outlook of the single investment manager who is also the promoter. Consequently, the results could lack impartiality and be somewhat biased.
The same can be said for the portfolio rebalancing and glide path strategies. With regards to rebalancing, the investment manager must opt for either a calendar-based, tolerance band or multi-period approach. In terms of the glide path, plan sponsors must select a specific time frame for each lifecycle movement and choose either a linear or non-linear approach. Despite the fact that in a proprietary investment solution the investment manager is usually responsible for all of the different asset classes, it is very unlikely this option will include a manager monitoring and selection feature to replace investment managers who are chronically underperforming. Under this scenario, the promoter will most likely have access to only one view pertaining to the direction and magnitude of currencies over the short and long terms. As a result, the manager’s decision on whether or not to hedge the non-Canadian dollar portfolio exposure will most likely reflect this single view.
Despite some of its shortcomings, the proprietary investment solution can be a viable alternative for plan sponsors and, more particularly, for plan members who want to minimize investor confusion and maximize simplicity.
Non-proprietary solutions
Non-proprietary investment solutions are often multi-manager offerings whereby the investment managers are totally independent from the promoter. In many cases, the promoters include DC recordkeepers and/or asset management consultants.
Non-proprietary solutions can also be one-dimensional or two-dimensional propositions and can be either actively or passively managed. But unlike proprietary solutions, they often include a combination of both active and passive investment management. Under a one-dimensional scenario, the plan member input would be limited to the expected retirement date or expected time horizon. Whereas, under the two-dimensional scenario, the plan member input includes both the time horizon and the investor risk profile. In either case, a multi-manager proprietary investment solution is usually very much aligned with plan sponsors that are keen on developing efficient risk-adjusted portfolios that are reflective of the specific investment policy of their plan members. In this case, the focus is on customization and minimizing overall portfolio risk and maximizing return per unit of risk. Under this scenario, all options are available to the promoter or plan sponsor, and specific decisions can be made at every stage of the product design and portfolio construction process to meet the particular needs of the plan members.
In terms of developing and designing the strategic asset allocation, the promoter can examine, evaluate and choose from among different optimization methodologies currently available for an effective retrospective look at past return, risk and correlation data as well as more effective tools to define the overall portfolio value at risk. In other words, it is more likely in this scenario that the promoter may have access to optimization methodologies that are different than the traditional mean-variance approach, which could provide a much better overall assessment of the fat tail risk associated with the overall portfolio.
The promoter also has access to different views on interest rates, inflation, equity risk premiums and other capital market considerations in order to better forecast future asset class returns. This should ultimately allow the promoter to develop a customized efficient frontier that will determine which asset classes to include in the portfolio and the specific weighting of each class. The number of different managers to include in the overall portfolio will often depend on the asset size of the plan and the specific objectives within each asset class. In order to maximize economies of scale and minimize costs, the number of managers should be positively correlated to the asset size of the plan.
The next step of the portfolio construction process usually requires a number of important decisions to be made at the level of each specific asset class, including (per asset class) active versus passive management, the number of different managers and the number of investment styles. The active versus passive decision will depend on the promoter’s view related to the market efficiency of that particular asset class and on whether or not there are active managers who can consistently outperform the asset class benchmark or index over the long term. The number of unique investment managers per asset class will be driven by the level of assets available and the number of different investment styles that will be required within each specific asset class.
The idea behind combining different investment managers, investment styles and investment approaches such as value, core, GARP, growth, bottom up, top down, qualitative and quantitative is to minimize the overall portfolio volatility, particularly over short- and medium-term time horizons. Some of the longer-term portfolio objectives also include minimizing manager risk, sector overlap and stock redundancies, as well as minimizing the overall absolute and relative risk of the portfolio.
Regarding choosing a specific rebalancing strategy aligned with plan member needs, the promoter once again should have access to different alternatives such as calendar-based, tolerance band, symmetrical, asymmetrical and multi-period. The same can be said as it relates to making a decision on a specific glide path strategy. The promoter can most likely choose from a linear or non-linear approach and incorporate a unique predetermined time period for each lifecycle movement.
An important potential design feature with the non-proprietary approach is a governance wrapper, which includes an impartial, independent and unbiased investment manager monitoring and selection team and process that is responsible for removing and replacing investment managers who consistently underperform. The promoter should also have access to different views on the short- and long-term direction and magnitude of currencies. Consequently, a currency strategy can also be included in the portfolio construction process, which could result in a decision whether or not to fully hedge the non-Canadian dollar portfolio exposure.
Another alternative of least regret may be to hedge only half of the non-Canadian dollar portfolio exposure. Obviously, the non-proprietary investment solution can be an interesting alternative for plan sponsors and plan members who are looking for a more sophisticated approach—one that is more reflective of their unique retirement goals and objectives. Note, however, that this option could prove to be more expensive and somewhat complex for certain DC plan members.
The evidence would suggest that, now, more than ever, DC plan sponsors and promoters are under a heightened level of scrutiny to ensure that the investment solution they choose will, in fact, do the job and allow DC plan members to achieve their retirement goals and aspirations. Consequently, regardless of whether plan sponsors select a proprietary or non-proprietary investment solution, it will be incumbent on them to prove to all of the relevant constituencies that their choice is not only compliant with the CAP Guidelines but also well thought out and based on research, rigour and sound judgment. The work doesn’t end there. Plan sponsors must also demonstrate that there is a systematic process in place to ensure that the investment solution is monitored and updated to reflect the evolution of DC plan member retirement needs as well as that of the Canadian DC landscape.
Nick Iarocci leads the investment program at the Standard Life Assurance Company of Canada in Montreal.