RISK MANAGEMENT
The clear articulation of risk measurement, sources of risk and its application to the portfolio management process within the investment policy statement is critically important. At the total fund level, surplus at risk can be quantified and directed should the level fall outside of a given tolerance range. Risk at the asset class level can be monitored by setting volatility guidelines, right down to the sub-asset class level. Portfolio level risk, in the form of active risk or tracking error, can be monitored and actively managed. Guidelines should state the expected volatility for a given asset class, establish baseline volatility and then direct a range around this figure.
Risk metrics are often backwardlooking and take into consideration past performance—a problem that cannot be diversified away. Holdings-based analysis (which identifies factor changes to alert a plan sponsor to changes within a given portfolio) can provide forward-looking metrics that can be measured, acted upon and potentially diversified prior to portfolio returns becoming a reality. Scenario analysis is a tool that can provide insight into potential changes in risk levels when new managers are considered for inclusion within a given fund portfolio.
MANAGER EVALUATION
One of the primary issues surrounding DB plans, foundations, endowments and other institutional investors is individual manager performance and monitoring. The investment policy statement should clearly state the process to be followed with respect to the hiring, probation and termination of external and internal investment managers. It is strongly suggested that these criteria are established and signed off at the beginning of a new relationship with a given manager. That said, it is important to remember that performance is merely a by-product of skill and consistency in process. Too often, performance becomes the primary driver of decisions to hire and terminate investment managers.
Best practices for investment manager hiring focus on several components: people, philosophy, process and performance.
People – Guidelines can include language to set minimum parameters for investment experience within a given firm and with a given product. Additionally, the guidelines can initiate a course of action based on the movement of people into or out of a firm.
Philosophy – Although this area can be the most challenging to quantify, it is imperative that managers clearly articulate their investment philosophies at the outset of a mandate.
Process – Consistency of process can be measured and monitored through techniques such as holdings-based analysis. Returns-based applications can alert plan sponsors to style or size drift through the use of regression analysis. Language within the investment policy statement can clearly identify how managers will be reviewed based on this type of criteria.
Performance – When reviewing performance- based metrics, certain measures such as peer universe comparisons are often part of the decision to retain or terminate a given manager. The statement of appropriate size/style universe comparisons, based on the expectation of size/style bias within a given mandate, is critically important within this section of the guidelines. Ultimately, the question arises around a given manager’s ability, or inability, to outperform its stated proxy after fees. If this test is failed, either the manager must be terminated or the particular investment strategy should come into question.
POLITICAL, ECONOMIC AND SOCIAL FACTORS
In a perfect world, all investment ideas for a given pension fund, endowment or foundation would have a single goal in mind: the modern prudent investor standard, which focuses on the overall portfolio’s risk/return profile. The fiduciary’s central consideration should be the trade-off between risk and return, per the CFA Institute Standards of Practice Handbook. Also important are the risk of loss and opportunity for gains, and the diversification, liquidity, cash flow and overall return requirements of the assets. However, political, social and geographical home country influences can affect the investment decisions made by a plan sponsor. The influence of local investment or investment in socially responsible concerns should be clearly stated within the body of the investment policy guidelines statement. Best practices dictate that any investments, socially responsible or otherwise, must possess an economic outcome whose focus is in the best interests of the beneficiary.
The task for the DB plan, endowment or foundation is clear: to meet pension obligations or spending rate targets as outlined within the investment policy statement. If nothing else, best practices for the construction of investment policy guidelines should include consistency of process, quantification of goals and rules of conduct, and thoughtfulness surrounding risk and its implications. Investment policy statements need to be dynamic, taking into consideration current market trends and incorporating the most up-to-date investment practice. And, most important, they must provide guidance for trustees, creating a template from which prudent decisions can be made on behalf of their constituency.
Steven R. Pines is senior investment consultant, U.S. and Canadian public funds, with The Northern Trust Company. sp16@ntrs.com
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© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the September 2008 edition of BENEFITS CANADA magazine.