Wednesday, October 10, 2012

Are Pension Funds Adding More Risk?

Craig Wong of the Canadian Press reports, Pension funds adding risk in hope of bigger returns:
Pension fund managers are looking at taking on more risk in their portfolios as they look to boost returns amid low interest rates and volatile stock markets, according to a report by Pyramis Global Advisors.

Derek Young, president of global asset allocation at Pyramis, said pension plans in the survey in general have set “very high expectations” for investment returns and in order to meet those goals are rethinking their investments.

“They are really reaching for risk and particularly they are going more toward alternatives and even more specifically they are going toward illiquid alternatives,” Young said.

Investment return expectations vary around the world, but Canadian plans on average expect a six per cent return, according to the survey. That compared with eight per cent in the United States and five per cent in Europe and Asia.

However, the survey found 36 per cent of fund managers felt they would not achieve their expected return over the next five years, including 40 per cent in Canada.

“These targets and their ability to achieve them are under an incredible amount of pressure,” Young said.

Pension managers have taken a double hit in recent years.

While stock markets crashed during the financial crisis and have been volatile ever since, defined benefit plans have also seen their liabilities soar due to falling interest rates, which are used to calculate the cost of promised benefits.

The combination has put many plans into a deficit position, leaving them with less than they would need to pay pensions in the future if they were forced to wind up today.

The Pyramis survey covered 632 corporate and public pension plans in 16 countries around the world, including 92 Canadian pension plans. In total the plans included in the review held US$5 trillion in assets.

Young said the traditional view of pension fund managers of focusing on the long term is changing as they take a more tactical view of investing.

He said pension fund managers are rethinking their approach to asset allocation and looking at using more aggressive classes such as emerging market stocks and debt.

And while 48 per cent have been reviewing their risk management measures more frequently since the financial crisis, 41 per cent said they were being more tactical in their asset allocation decisions.

But Young notes that being aware of risk in a portfolio doesn’t eliminate the risk in a portfolio and he said illiquid assets can make a portfolio appear less risky than it actually may be.

Unlike stocks, which can be bought and sold every day, the value of an illiquid investments like big infrastructure assets aren’t really known until it comes time to sell.

Last week, a report by consulting firm Mercer said its pension health index, which measures the ratio of assets to liabilities for a model pension plan, stood at 80 per cent at Sept. 30, up from 77 per cent at June 30, helped by strong returns on the stock market.

Mercer said Canadian stocks returned seven per cent in the third quarter to bring the return for the first nine months of the year to 5.4 per cent.

However, the firm noted that the majority of pension plans still face significant solvency deficits.
Even if stocks continue to climb the wall of worry, which is what I'm betting on, it won't make a big difference to pension deficits which are much more sensitive to interest rates. In other words, significant solvency deficits are here to stay and plan sponsors and their stakeholders better address this issue head on.

And Young is absolutely right, being aware of risk in a portfolio doesn’t eliminate the risk in a portfolio and illiquid assets can make a portfolio appear less risky than it actually may be. Shoving billions into illiquid real estate, private equity and infrastructure is the mantra of the day but it doesn't eliminate risk, it only masks it, amplifying losses in a severe downturn.

True, pensions are long-term investors and can ride out any storm, but the harsh reality is that the 2008 crisis exposed how most pensions were not managing liquidity risk properly. As I stated in my last comment on CalSTRS considering asset risk factors, shoving more assets into illiquid alternatives is no panacea, and can turn out to be lethal if a protracted debt deflation cycle engulfs the global economy.

Also, the approach to illiquid alternatives is critical. Large Canadian pension funds  have the governance model and compensation scheme to manage assets internally, significantly lowering the cost of these private investments. This has been a key factor of success for the Oracle of Ontario and others trying to replicate Teachers' success.

As far as other factors pensions are considering, April-Scott Clarke of Benefits Canada also reports, Pension funds rethinking risk, investing models:
Pension fund managers are concerned about their long-term returns, with 40% of Canadian institutional investors surveyed in the 2012 Pyramis Global Institutional Investor Survey saying they don’t think they will meet their annualized target returns over the next five years. To battle this, plan sponsors are becoming more tactical when it comes to their portfolios and are rethinking their asset mix.

Increasing risk
Thirty-eight percent of respondents said they are increasing their use of illiquid assets, which Derek Young, president, global asset allocation, and vice-chair with Pyramis Global Advisors, says is an indication that they are looking for more transparency.
Twenty-nine percent are increasing their use of more aggressive sub-asset classes, 22% are increasing their use of liquid alternatives, 18% are allowing more flexible mandates, 15% are increasing their risk within an asset class, and 15% are increasing their use of concentrated equity strategies.

Although people are “reaching for risk” to increase their returns, says Young, they are being smart about it. Forty-eight percent of plans say that, in the last three years, they have increased the frequency at which they conduct and review risk measures, and 11% have purchased a better risk management system. “Gone is the set-it-and-forget-it state of mind; now it’s buy and review,” says Young. “If you are taking more risk, you need to review it more often.”

Asset mix
Pension fund managers across the globe, but Canadians in particular, are very open to rethinking the traditional asset allocation model (i.e., allocation by asset class). When asked, 52% of all respondents (including those from the U.S., Europe and Canada) said yes, they were rethinking the traditional asset allocation model, but of the 52%, 79% of Canadian investors said the same. “There is no downside to re-evaluating what you are doing,” says Young. “I think it’s a positive move.”

New views
And, following this trend, many plan sponsors feel that new investing techniques are the way of the future. Forty-three percent said that new asset allocation models would be the likely future for pensions.

New models would include the following:
  • factor-based (19%);
  • alternative (12%); and
  • absolute return (11%).

However, most felt that the traditional models would still dominate, with 26% of global respondents saying that a fixed income/immunized model would be the most likely future for pension allocation; 19% said it would be the traditional 60/40 mix, and 12% voted for the global model (equity and fixed income).
Those of you wanting to learn more on the 2012 Pyramis Global Institutional Investor Survey, can do so by clicking here. You will find several video clips explaining various regional results, as well as the US press release and the global press release. Also, State Street Global Advisors posted a survey on tail risk strategies, Managing investments in a volatile market, discussing investors' perceptions of such strategies.

From the strategies outlined in the article above, I think it makes sense for pensions to increase their use of more concentrated equity strategies. In a world dominated by high-frequency trading and insane price movements, the only way to beat computers is by taking concentrated longer-term positions, accumulating out-of-favor industries at the right time.

Taking more risk at a sub-asset class level and more risk within an asset class can also enhance returns but it exposes pensions to serious downside risk too. Again, go back to read my recent comment on when career risk reigns to appreciate what a challenging environment this is for large funds looking to achieve their actuarial return targets and how tactical asset allocation can help them achieve these targets.

As far as allocating more to liquid alternatives, I note that liquid hedge fund strategies have seriously underperfomed less liquid strategies over the last year, and are underperforming the stock market once again. According to Opalesque, securitized credit funds returned +13.7 percent year-to-date (YTD) through September compared to +4.9 percent for the HFN Hedge Fund Aggregate Index. Structured credit has been a boon to investors as these strategies benefited the most from QEinfinity.

Interestingly, hedge funds are also beginning to take on more risk. Reuters reports that US hedge funds are increasing their leverage and the FT reports that some intrepid hedge funds have tiptoed back into Greek government bonds. The country’s benchmark 10-year bond, for example, has more than doubled in price since the nadir in late May – to just above 30 cents in the euro (hedgies may be right betting on Greece) .

Below, Lasair Capital CEO Carrie McCabe discusses hedge fund performance in the third quarter. She speaks with Pimm Fox on Bloomberg Television's "Taking Stock."

And White Box Advisors' Jason Cross, Robert Vogel and Paul Twitchell talk about equities, hedge funds and their investment strategy. They speak on Bloomberg Television's "Market Makers."