Concentrating on liabilities
Over the past five years risk analysis has become a key concept in the fund management industry's handbook. As a result, the landscape has altered and investment consultants, like their clients, have had to rethink their role and the products and services on offer. Although the traditional firms are changing the way they do business, independent players as well as investment banks are vying for business.
The reasons for the shift in the sector have been well documented although, not surprisingly, it has taken time for the new way of thinking to sink in. According to Sathish Ramdayal, senior consultant at Edinburgh-based financial risk consultancy Barrie & Hibbert, the market crash in 2000 followed by the Myners Report and a raft of new accounting standards such as International Accounting Standard 19 and FRS 17 in the UK have sharpened the focus on the asset and
liability match of a pension fund. The outcome has been a new emphasis on liability driven investing and a plethora of risk management tools that in many cases involve the use of swaps and derivatives to hedge risks such as inflation or interest rates. Absolute return strategies to give the fund that extra alpha boost have also gained appeal.
It is no surprise that investment banks, with their long-established track records in derivatives and structured products, have taken advantage of the new appetite for risk solutions.
They have been actively marketing their risk management wares to the pension fund community, although their client base is derived mainly from the blue chips with which they have long standing relationships.
The smaller and medium-sized pension funds in particular prefer the status quo of using a consultant and it is likely that competition for business between the banks will focus on the larger pension fund accounts.
The investment consultants whose roots are in the actuarial business have been slower off the mark, but have been busy broadening their skill sets and menu of products to meet the new risk/return requirements. Banks and larger consulting firms have been poaching talent from each other as well other advisory firms to bolster their pension advisory businesses.
For example, last November Watson Wyatt hired Kambiz Deljouie, head of structured risk finance at ABN Amro, while Morgan Stanley, which has one of the biggest pensions advisory businesses in Europe, hired Neville McKay, a partner at PricewaterhouseCoopers, to head its European pensions group.
Mark Duke, a UK-based principal at Towers Perrin, notes: "We were in the traditional camp but if I were going to give one label as to what we do now it would be risk management. In the past no one sat down and expressed intuitively what the risks were. At the moment, most of the corporates we work with want us to paint a picture of the things that could hurt them and how they can get them off the table."
This involves a variety of services ranging from advice to risk metrics, analytics to implementation and derivative solutions. Towers Perrin has been building an expertise in structured products and will act as a go-between between a client and an investment bank, particularly when a tailor-made product is required for a sophisticated strategy.
As for the independent firms, it is an advantage to be smaller and nimble. Many saw an opportunity right after the markets crashed six years ago and started building a different type of business model which included risk management tools, derivatives strategies and professional and transparent risk and value contribution models. They also spotted a gap in the market with small- to medium-sized pension funds that were beginning to think of using risk management tools but did not have the internal resources to develop their own strategies.
Frank-Christian Corell, managing director of Fin Risk, a Frankfurt-based risk consultancy founded in 1999, attributes the specialist consultants' success to the depth and breadth of detail embedded in their risk models.
Corell notes that in general the job of external consultants across the spectrum has moved from providing event/situation driven advice to enabling organisations to conduct their own risk analysis and decision making processes. It has also changed from focusing on solutions in one business area such as investment, reinsurance or product pricing to adopting an integrated approach to a pension fund's needs.
"We provide a holistic approach which does not just focus on specific issues such as manager selection or asset allocation," Corell says.
"We develop a plan tailored for that specific client that incorporates risk modelling, implementation, training and development of corporate governance standards, together with executives of the client company. We look at ourselves as a niche player with a wider view. Risk management is not a target in itself. It is there to create value and one of the most important things is to identify and quantify the relevant risks early on."
"There has been a real difference in the consulting business in terms of what services and products are being provided," notes John Conroy, a principal at specialist investment consultancy P-Solve Asset Solutions, a Punter Southall subsidiary started in 2001.
"It has become a much more complicated business and is no longer just about giving advice. We have what we call total investment governance solutions whereby we work with the client and other advisers to develop a framework which carries on through from advice to implementation." Conroy also notes that overall derivative strategies have become more widely used.
"Pension funds have a greater understanding of risk and that it does not just mean the standard deviation of returns. There can be 10 different
types of risk, ranging from the covenant risk and the viability of the corporate sponsor to inflation and interest rate risk. A derivative strategy will be increasingly used to manage some of these risks."
Martijn Vos, the Netherlands-based head of the pension fund advisory group at Ortec agrees that pension funds want models that drill down deeper into the nitty gritty components of risk.
"From the development side, it has become important to provide a more detailed analysis of the risk and where it comes from. Five years ago, clients were interested in inflation and interest rate risk. Today, they want to know about risks such as equity, credit and counterparty."
Ortec, which started life as a logistic software house in the early 1980s and added a financial consulting arm in 1998, has an assets and liabilities scenario-model that performs a variety of functions. They include making actuarial costing forecasts, carrying out asset liability studies, generating future liabilities forecasts and conducting risk analyses.
Although risk management may be the buzzword, investment consultants believe that pension funds are beginning to see how risk can also be used to enhance returns. "In the 1990s, the focus was on return," Ramdayal explains. "The focus changed to risk following the market dislocations of the early 2000s. However, at the moment, clients are trying to balance risk and the return budgeted for in their actuarial funding valuations. They are looking at models such as derivative strategies, which will alleviate the risks."
Barrie & Hibbert, which has an insurance background, has developed a variety of risk models that it licenses to pension funds, typically the smaller and medium-sized players that may not have the resources to develop their own, as well as to investment consultants. The goal is to arm the end user with the right tools to make their own decisions.
Consultants have also become increasingly involved in the decision-making process, including selecting the right fund managers for a job. Pension funds, of course, want a person with a track record although they are not just looking for yesterday's stars; they want people who are au fait in the alternative world and can generate returns in difficult markets.
"Choosing managers can be difficult as there are thousands of managers and products on the market," Conroy says. "We apply quantitative and qualitative screens - some of which are proprietary - to cut the list down."
"We have been in the business for 10 years and have found that institutions want us to become more involved in helping them make decisions," says RiskLab managing director Gerhard Scheuenstuhl based in Munich. "It is not just looking at the specific risk profiles but also looking at alternatives such as private equity, commodities, hedge funds to see what impact it could have on a portfolio."