In this final article on a new survey, Pierre Cailleteau and Amin Rajan conclude that improved risk management is the most enduring legacy of the global financial crisis
Since the Lehman collapse in 2008, the distinction between the three aspects of risk has become clearer for pension investors: its understanding, its measurement and its management.
The new generation of risk approaches go beyond the familiar VAR analytics and seek to identify the causes and consequences of risk. Risk is no longer equated with volatility. Instead, it is defined by the maximum drawdown that trustees will tolerate in a given year, according to Amundi Asset Management/CREATE Research 2014 Survey, The Alpha Behind Alpha: Rebooting the Pension Business Models*.
The causes of risk are being separated from its consequences; its management from its measurement; its time dependency from its randomness. To manage it, therefore, our survey respondents distinguish between implicit hedges and explicit hedges: one indirectly relies on the choice of assets to hedge out the portfolio risk; the other relies on overt mechanisms to control it.
Four tools are now deployed by at least two in every five respondents to hedge out their risks implicitly (see figure): greater asset class diversification (78%), asset allocation based on risk factors (49%), duration management (48%) and liability-driven investing (41%).
In contrast, four tools are being used to hedge them explicitly: inflation, interest rate and mortality swaps (30%), tail-risk hedges (18%), option contracts with asymmetric bets (9%) and stop-loss mechanisms (6%).
The less widespread use of explicit hedges is attributed to their cost, which can be a drag on performance. They also add complexity to the portfolio: some are single-period, some multi-period; some cover individual securities, some the whole portfolio. Worst of all, they are exposed to counterparty risks, if many investors are forced to activate their hedges at the same time; as happened when AIG collapsed in 2008. As if that was not enough, the ‘flash crash’ in the US in May 2010 exposed the weakness of some of hedges such as option contracts and stop-loss mechanisms.
Thus, asset diversification remains the most used tool for implicit hedging (78%). Many plans are still seeking a free lunch from diversification via periodic rebalancing. For them, rebalancing provides a hedging tool, when new risks emerge. But that is not all. Some plans have started using diversification to manage unquantifiable but tangible tail-risk. Low carbon strategies are an example. They aim to protect against the materialisation of tail risk associated with environmental pollution.
Most notably, though, plans have gone further and based their asset allocation on risk factors, using the concept of risk budgets (49%). Factors come in many flavours. First, there are macro factors such as GDP growth, inflation, volatility or real interest rates. Then there are equity-specific ones like size, value, momentum, variance and currency. Then there are bond-specific factors like capital structure, duration, credit spread and default risks (see case study). This approach is hailed as an advance in risk management: it identifies risk via a laser-sharp focus on its sources; it measures risk in relation to liabilities; and it manages risk via the appropriate mix of assets.
A Swedish case study
“The conventional wisdom on diversification came unhinged when it was needed most – in the global financial crisis of 2008. The Yale model favouring alternatives did as badly as the long-only model, favouring mainstream assets. It was cathartic.
“Our starting position was different asset classes can have high correlations due to their common exposure to underlying risk factors. These are the smallest systematic units that influence investment return and its associated risk. So we have started down the road of risk-factor investing.
“There is no natural way to invest directly. There is no consensus about the link between, say, GDP growth and equity returns. The factor risk and return can be time sensitive. Predicting the future path of the factors is fraught with assumptions.
“At this early stage, therefore, we are using risk factors in two respects. First, we analyse the behaviour of all asset classes under various macroeconomic scenarios, involving GDP growth and inflation; and identify the right assets for each scenario. For example, for the high growth/low inflation scenario, we choose equities and corporate debt. In the low growth/rising inflation scenario we choose commodities, infrastructure and inflation-linked bonds.
“Additionally, in equity investing we use smart beta strategies with distinct tilts towards value, momentum and low variance. They have delivered good returns over the past three years.
“Over time, we will extend this to fixed-income investing by using fundamental indices. Our goal is to deploy risk factors to minimise the correlation between return-seeking assets and the liability hedges.”
Fear and uncertainty can be toxic. Pension plans can’t afford another ‘lost decade’. But over caution carries its own risks. Hence, implicit hedges are seen as a good comprise.
However, success is predicated on sound governance. As the distinction between the measurement and management of risk has crystallised, the role of human judgement has grown in importance. A strong risk culture has demanded high quality dialogue between trustees and full-time executives backed by good execution capabilities.
If there was a recurring theme, it was this: the view that ‘time heals all wounds’ is less true when it comes to investing. The business model changes implemented by pension plans, as described in our report, may not futureproof their portfolios. But they have improved their portfolios’ resilience in the face of continuing market turbulence. Diversification based on risk factors and tail hedges are a far cry from the conventional VAR-based 60:40 equity-bond mix.
Pierre Cailleteau is the global head of institutional and sovereign clients at Amundi Asset Management and Amin Rajan is CEO of CREATE-Research
* A copy of the report is available here