The Netherlands: The yin and yang of investing
De Nederlandsche Bank (DNB) advocates strict separation of risk management and fiduciary management. But Lodewijk van Pol, head of fiduciary management at Lombard Odier, argues that risk management and fiduciary management are joined together at the hip and that is just the way it should be
Two interviews with representatives of DNB (Dutch Central Bank), Femke de Vries, Paul Hilbers and Bert Boertje, (see page 49) in which governance and risk management of pension funds were examined. Observations and opinions were aired as part of the ongoing investigation into the investment policies of pension funds. Among subjects that were reviewed were implementation risk, expertise of pension fund boards and outsourcing of asset management. One of the striking themes was DNB's vision of a rigorous separation of asset management and risk management.
This concerns fiduciary management in particular, which, in the eyes of the supervisor, seems to be a compromised business model.
A couple of quotes from the interview: "Some tasks should simply be separated. Asset management and risk management - it really is in the nature of these tasks to separate this." and "Fiduciary managers who also conduct asset management and with that have to more or less check themselves. It then becomes clear that the role of risk manager is no longer possible; the overlap of tasks will quickly start to squeeze".
Clearly this vision is aimed at avoidance of conflicts of interest, or just these ‘opposites', as is described in the specification of outsourcing risks in the financial institution risk management (FIRM) handbook. But no doubt DNB's vision is also based on the legal framework formed by the Pensions Act, as well as the principles of pension fund governance and the rules on outsourcing.
By using a number of propositions I would like to argue in this article that risk management and fiduciary management are inseparable, and not in last place because of governing rules and regulations and supervision.
That is exactly why pension fund objectives - securing nominal payments and the pursuit of indexation ambition (targets) - and the interests of participants and those of pensionable age, are best served if asset management and risk management are under integrated control. I will try to avoid a semantic discussion about defining risk management and describing fiduciary management. Instead, I will present a vision based on daily practice and connected to that, choosing a suitable fiduciary manager. In addition, I think that the ‘prudent person principle' should be used as a starting point.
The simple starting point of investing in the interest of the pension objectives, when applied correctly, puts a pension fund board in control - the primary task and responsibility of a fiduciary manager.
Separation of risk management and asset management increases implementation risk and implementation costs. Two characteristics distinguish the fiduciary manager from a traditional asset manager: implementation according to the ‘best practice' principle - active, or passive through outsourcing to other parties - and balance sheet management. This last principle is actually the crux of fiduciary management and ensures the connection to the pension fund objectives and available risk budget of the pension fund. Think, for example, of the reliable and effective interest rate matching and daily monitoring and reporting of the coverage ratio and risk positions in the investment portfolio. Not only do you need detailed knowledge of the structure of the pension fund, its objectives and liabilities, but also the entire asset management organisation, the procedures, the people, the systems and reporting should be based on that. This adds up to a well-oiled machine with risk budgeting and pension objectives as a starting point.
As soon as the asset manager - as often happened in traditional pension fund management - merely has to focus on an imposed investment benchmark, with or without an outperformance objective, the connection with the objectives of the pension fund is compromised and the view on an effective implementation of the chosen investment strategy is clouded. That is exactly the point that DNB is warning us about and which has been pointed out by the Frijns Committee. ‘Alignment of interest' is the key phrase here. How can you achieve that if the responsibility of risk management and asset management is separated and in different hands, as far as that is even feasible? Is DNB maybe confusing risk monitoring with risk management?
Fiduciary management offers a solution for a dynamic investment policy. The (aftermath of the) credit crisis has started a discussion about the added value of asset liability management and particularly about the apparently static assumptions with regard to investment risks and risk premiums.
One also wonders if and how the investment policy can be made dependent on the coverage ratio of the pension fund. In a lot of ALM studies a fairly rigid investment policy is assumed with fixed norms and bandwidths with regard to the asset allocation. This is contrary to the premium and indexation policy that in many cases is indeed dependent on the coverage ratio and the objectives of the pension fund. This question is even more interesting in view of the decreasing effectiveness of premium policy and the relatively small relevant role of indexation policy in an actual deflationary economic environment.
But the pitfall of a dynamic investment policy is the slide towards opportunistic tactical asset allocation or mechanic or procyclical investing - not to mention the system risks of portfolio insurance of similar non-linear solutions. Dynamic investment policy is, therefore, an unruly matter that demands common sense on the one hand, and in-depth analysis and discipline on the other hand. If a pension fund wants to get a grip on it and be more ‘in control', fiduciary management or integrated asset management would be the way to go, in my opinion.
An interesting approach in this context is, for example, the application of regime analysis as a starting point for the estimation of risk and as a basis for the working of financial markets.
In connection to that, a concept like risk-weighted rebalancing is applied, which avoids the negatives of mechanical re-allocation. The basis of this approach is the assumption of unstable volatility and correlations between equities and capital interest rates in particular, in which re-occurring patterns can be recognised, thus providing a framework for the analysis of a pension fund's balance sheet risk. In practice, this will only work effectively and efficiently if asset management and risk management are seamlessly integrated.
Additionally, this also demands vision and insight in current markets and the economic environment. A good risk manager and asset manager does not limit himself to quantitative analysis only, still the most extreme form of abstraction, but also assesses the topicality based on knowledge, experience and common sense.
Separation of asset management and risk management increases the pension fund's problem regarding expertise. This proposition follows logically from the previous propositions that risk management and asset management are inextricably linked - the yin and yang of investing. As long as every investment proposal to the pension fund is measured against the yardstick of the prudent person principle (contributing to the pension fund objectives) it becomes understandable and explicable. Suppose ‘the asset manager' goes hunting for return. Subsequently ‘the risk manager' will bring that back under control. This introduces a conflicting governance model that simply does not contribute to insight and comprehension for the pension fund board.
In my view the expertise problem of the pension fund board has little to do with the limited technical knowledge regarding the concepts of basis point value, volatility of the swap spread or ‘QE2'.
The million-dollar question for the pension fund board is always the same: how does the investment policy help me to meet the pension fund objectives? That is often unclear, precisely because asset management and risk management are presented as two separate disciplines. This schism should not be enlarged. It should be removed. Fiduciary management achieves the symbiosis of risk management and asset management, painting a clear picture. This approach allows the so-called ‘incompetent' pension fund board to receive the correct reports, to ask the right questions and to take the correct decisions.
Of course, DNB's criticism did not fall out of the sky. Some pension funds have experienced major problems with complex, non-transparent structured products, which imploded after the credit crisis. Or with broadly defined active investment mandates, particularly with regard to tactical asset allocation. This has led to large and often unrecoverable losses. In my view, this is caused by deviating from the pension fund objectives and releasing the prudent person principle. This should actually be anchored in clearly defined investment guidelines and contractual provisions.
But maybe there is also a connection to the business model of the fiduciary manager. The equal treatment of the pension fund's objectives and the professional orientation of the fiduciary manager should be presented convincingly when outsourcing the asset management. The discipline and responsibility commanded by competition, market forces and professional client orientation can be a helpful criterion.
Lodewijk van Pol is head of fiduciary management at Lombard Odier