GLOBAL - Active management and risk management are key parts of a pension fund's armoury in the post-crisis financial environment, according to Union Investment's head of quantitative strategies Thorsten Neumann, but liability-driven investment (LDI) is expected to take on renewed importance.
"The crisis has changed financial conditions, not only in the short-term, but longer-term, too," said Neumann at the IIR Finance Performance Attribution Risk Management (PARM) conference in London yesterday.
Reduced leverage will result in lower growth, but increased global synchronicity of business cycles will make economic cycles shorter and more intensive. Market volatilty will go up, there will be more 'fat-tail' events, risk premia will go down and returns will be lower. Active management will therefore become more important, both in terms of stockpicking and actively managing beta exposures, suggested Neumann.
So adding value through diversification - through dynamic asset allocation, between alpha and beta streams, and among alpha sources - will be key in a world where there are no new asset classes to discover, according to Union investment's quants expert. But LDI will also be more important, because higher volatilty and lower risk premia will lead to reduced risk budgets, limited investment opportunities, and a greater challenge to the idea that liabilities can be met by allocating to risk assets for the long-run.
"It's not so easy to get the 5% return that you need anymore," said Neumann. "Buy-and-hold approaches face major challenges. Before, when interest rates were low, you could take equity risk and wait it out - but if you face such high equity volatility with such low risk premia that's not necessarily an option now."
Increased market volatilty furthers the case for abandoning traditional market benchmarks in favour of liability benchmarks, which would force investors to manage their alpha and beta streams more actively to improve risk-adjusted returns relative to underlying asset classes, Neumann argued.
"We need to make more investors aware of the LDI problem," he said.
Neumann acknowledged that LDI is a passive solution and pension schemes may wish to discuss whether implementing it makes sense in all interest rate environments. It pays to take active duration risk sometimes - and with yields so low now may be one of those times - although Neumann added this was a separate decision to that of implementing LDI as a strategic solution.
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