Back to the future
As we mark the five-year anniversary of living under the cloud of the 2008 financial crisis, we can also see a silver lining to it. The Roman poet Horace observed long ago that, “Adversity has the effect of eliciting talents, which in prosperous circumstances would have lain dormant.” And indeed, the 2008 crisis elicited the talents of the asset management com- munity, which responded with an array of new risk management tools designed to avoid losing money.
Now responsibility shifts to pension funds, and specifically to their governing bodies, to take advantage of these risk management innovations. There is really only one way to do that. Pension fund boards and their investment teams must form a new partnership. In this new arrangement, the boards give their investment teams more day- to-day control of risk management. The boards will continue to set return targets and stipulate how much risk the funds can take. But the investment team, operating within those guide- lines, should have complete flexibility to allocate assets and reposition the portfolio based on its ability to monitor risk on a real-time basis.
Let me back up. There were two important lessons of 2008. First, we learned that the traditional 60/40 diversification won’t protect a portfolio
in a global crisis. Second, investing with a long-time horizon – the buy-and-hold strategy – is over, at least for public pension funds. It may have worked for 60 years, but globalisation, the role of central banks, demographics, communications and complexity has relegated buy-and-hold to the dustbin of investment management history. The idea of pension trustees meeting once a quarter to update allocations and strategies is as outmoded as a paper road map in the internet era. The paper map is too static. It shows the route, but not this evening’s traffic jams, closures, time saving detours, or new restaurants.
As difficult as it is to let go of such a powerful idea as buy-and-hold, regulators worldwide aren’t giving fund trustees a choice. In the Netherlands, if a fully-funded pension fund misses its target, it has a maximum of five years to make up its losses through some combination of cutting benefits and/ or increasing contributions. In the US, losses must be made up in seven years; in the UK, 10 years. Given this strict new regulatory environment, pension funds must now adopt a twin focus: making money – but also not losing money. Stellar returns or even beating benchmarks are nice, but they should no longer alone dictate strategy.
At the CERN Pension Fund, the losses of 2008 prompted a re-examination of our investment assumptions. The pension fund’s board, largely comprised of scientists with a natural openness to new ideas, was receptive to change. It understood that beating the S&P 500 wasn’t sufficient. As the saying goes: ‘you can’t eat relative performance’. It also understood that placing long-term bets on equities doesn’t work if, in the short-term, losses create negative cash flows for the fund. The CERN Pension Fund is a mature fund whose retirees are drawing down their benefits. In other words, it did not have the luxury of waiting 20 or 30 years to make up its investment losses – it needed cash today.
In a dramatic departure, the board in 2010 adopted a radically new invest- ment governance framework that gives more day-to-day responsibility to the investment staff. Simply stated, the CERN model aims to set risk limits, and within those limits achieve the highest possible investments returns.
In this new partnership, the board outlines the investment principles, sets the guidelines and dictates the objectives, but leaves the execution to the investment team. The board is analogous to the passenger in a London cab. The board/passenger gives the destination, but lets the cabbie/invest- ment team determine the best route without taking excessive risks – no
speeding, getting stuck in traffic or get- ting arrested. The message is simple, but adhering to it requires discipline, particularly when the market outlook seems too bright or too dour.
To ensure the strongest possible board control, the CERN model man- dates a three-part reporting process – from the custodian, from the internal staff, and from outside, third-party monitors who provide assurance on risk and process compliance by staff. And in a final break with tradition, the board no longer evaluates the fund’s performance by comparing it to generic benchmarks. Instead, performance is evaluated on the fund’s meeting or exceeding its own return objective, on its success in preserving capital, and on its skill in risk taking. The new partnership increases the chances that the fund will perform better because it frees up the investment team to fully apply its skills and talents.
This model has been described as ‘back to the future’. Before the inven- tion of modern portfolio theory and its accompanying reliance on diversifica- tion to manage risk, the goal of pension funds was simple: earn more than cash and not lose money. The hardships of 2008 have re-taught us that lesson.