June 2011

RESEARCH: Making use of risk management

MonkeyEmpirical tests would surely show that pension funds using risk management tools would have superior results. But the reality is more complex, explains Samuel Sender of Edhec-Risk Institute.
In the asset management industry, there have been empirical tests of the ability of qualified asset managers to beat the market (including the famous and disputed test showing that a monkey throwing darts at a dartboard would beat the average fund manager). The general conclusions from these studies seem to be that markets are efficient on the whole: generating alpha requires processing information for a cost similar to alpha, and very few funds consistently beat the market. This article attempts to analyse the empirical benefits of risk management. One could think that, because of the great benefits of risk management, tests are likely to show that those using risk management will have superior results. The conclusion, as we will see, is more complex. In our recent Survey of the Asset and Liability Management Practices of European Pension Funds, which was undertaken as part of the Regulation and Institutional Investment Research Chair in partnership with Axa Investment Managers, we examined the ways asset-liability management (ALM) at pension funds makes use of modern investment management techniques. We attempted to split the sample in our survey into sophisticated and unsophisticated users of portfolio construction techniques and portfolio insurance strategies, our two major criteria. We then compared the ex-post risk-adjusted performance of the sophisticated and unsophisticated respondents. We have two measures for the performance of pension funds. We use the average funding ratio from 2005 to 2008 to proxy long-term performance. This proxy is imperfect but, in the absence of more detailed financial data, acceptable. The relative change in funding ratios from 2007 to 2008 makes it possible to assess how pension funds and their risk management have withstood the crisis. Although a limited number of funding ratios is available to us, our results highlight some salient facts. Long-term performance seems positively correlated with our proxy for portfolio diversification (and very slightly with the use of risk management), even though the predicting power is poor. Correlation, of course, is not causality: it is possible that the pension funds with the highest funding ratios pay higher salaries and make better hires; equally possible is that sponsors that have sufficient resources to fund their pension fund adequately may also staff it adequately. Efficient protection from falls in funding ratios seems, in practice, to be more highly correlated with risk management than with the use of dynamic asset allocation techniques. When linear regressions are done, we find that the use of dynamic
asset allocation techniques is positively correlated with the fall in funding ratios in 2008. By contrast, risk management seems more instrumental. Figure 1 shows the regression of long-term performance and protection from falls in funding ratios against the reported use of “dynamic strategies such as dynamic liability-driven investing (LDI)”. Those who report that they use dynamic ALM posted greater falls in funding ratios in 2007-2008, and economic capital seems to yield better results. This counterintuitive finding that dynamic asset allocation seems to offer no protection from falls in funding ratios requires clarification. Dynamic strategies are efficient to the extent that they are used in what could be called an integrated fashion. Some sophisticated respondents are not using these strategies at the balance sheet level, but only in some specific funds. Alternatively, pension funds do not have a holistic view of their risks and may neglect interest rate risk or sponsor risk. Despite their size and sophistication, for example, Dutch pension funds have experienced drops in funding ratios larger than those in other European countries, partly because they failed to take convexity into account. One could argue that for rule-based strategies to be efficient, rules need to be adequately defined. This incomplete use of dynamic asset allocation techniques affords incomplete protection. The inconsistency of some respondents is visible in our survey: some report that they do not take liabilities into account when defining their strategy investment process, yet they report that they use dynamic asset allocation strategies. Likewise, it can be argued that many Dutch pension funds failed to take into account the convexity of the duration of their liabilities in their investment strategy, and were hurt by growing interest rate sensitivity when falls in equity markets lowered their funding ratios. Figure 2 (Dutch funding ratios) shows that the average funding ratio of sophisticated industry-wide pension funds fell under the regulatory minimum in 2008. The use of risk-controlled investing (RCI) techniques is thus not sufficient to insure against risks; respondents must use these techniques in a consistent manner. We also find that the pension funds that best withstood the crisis are those that used risk management, in the form of RCI strategies or economic capital. That the most well protected pension funds are among those that master risk insurance techniques bolsters our view that risk management is essential to the definition of the investment strategy. In the recent crises, the increased correlations of asset classes have reduced the benefits of diversification and increased the benefits of risk insurance. Qualitative evidence from the field
To seek qualitative evidence of the benefits of risk management, we have analysed reports from the pension funds that have been mentioned in the press as having performed very well, and tried to assess their use of risk management, dynamic asset allocation, and derivatives. In most cases, strategies rely primarily on techniques inspired by economic capital management rather than on dynamic asset allocation. Pension funds are generally reluctant to apply fully dynamic asset allocation schemes, either because of organisational problems or simply because their processes are not sufficiently quantitative. After all, a more qualitative process that relies partly on investment committees is more consistent with their culture; so is economic capital management. Although there are not always direct mentions of liability-hedging portfolios in their annual reports, these pension funds mention clear processes for managing their liability risks (mainly interest rate risk). They often use swaps or swaptions to manage their interest rate exposure. Some survey respondents (ATP, the Danish pension giant, for instance) calculate their risks on a daily basis, and hedge their exposures accordingly. One respondent manages interest rate risk dynamically; a Dutch respondent (Rabobank Group), by contrast, relies on hybrid derivatives, where the payoff of a receiver swaption is linked to equity performance. Such a hybrid derivative can be seen as a proxy for the replication of an interest-rate sensitivity conditional on the funding ratio. After all, in the Dutch framework, interest rate risk falls when equities have performed well (since equities have a positive influence on funding ratios), so this joint option is equivalent to managing interest rate risk dynamically. Survey conclusions
Our first conclusion is that, despite the great professionalisation of ALM in pension funds and their service providers, risk-controlled strategies are not used by European pension funds as often as they should be. Pension funds prefer economic/regulatory capital approaches that theoretically provide risk insurance but involve discretionary, not rule-based, changes to asset allocation. Twenty-eight percent of respondents use RCI strategies, whereas 56% use economic/ regulatory capital to manage prudential constraints. But discretionary approaches to risk insurance make it very likely that the very mechanism that makes a strategy a risk insurance strategy is lost. Reliance on discretionary investment policies involves the risk of delays in implementation and the risk of relying on behavioural biases that distort the theoretical strategy. As it happens, respondents do not always use the strategy implied by their risk-management tools or models. Many
Dutch pension funds have failed to reduce risk as significantly as the FTK (financial assessment framework) regulation commands (they kept a larger share of risky assets than allowed by their funding ratio). In addition, discretionary strategies may be riskier than thought because of organisational challenges. Qualitative feedback shows that risk is often managed in silos (with departments acting separately) at pension funds, as it often is in banking. A silo approach generally leads to sub-optimal results because, at best, risk measures are sub-additive, so managing risk budgets independently is less suitable than managing them jointly (above all, when the risk allocation and the limits set for each department are revised too infrequently). Severe consequences
On the whole, because rule-based strategies are compatible with economic capital and prudential risk-based regulations, we recommend greater reliance on these strategies. Even though mathematical methods such as stochastic programming are required to derive the optimal asset allocation rules for risk insurance, very simple and intuitive approximations can be derived, and rules of thumb that require no minimum mathematical background can prove to be an efficient way to insure risks. For rule-based strategies to be efficient, pension funds must ensure that they have a comprehensive view of their risks, which the survey suggests is not always the case: prudential risk (the risk of underfunding) is managed by only 40% of respondents, accounting risk (the volatility from the pension fund in the accounts of the sponsor) by 31% of respondents. More than 50% of the respondents ignore sponsor risk (the risk that a bankrupt sponsor leaves a pension fund with deficits). Pension funds’ reluctance to manage their risks comprehensively may have severe consequences. First, this reluctance increases risk to no purpose. And the reluctance to manage accounting risks may also lead to inappropriate volatility in the sponsor’s books, volatility that may trigger closure of pension funds in countries such as the UK, where there is no obligation to provide defined benefit plans, or to limit the support of sponsors in countries such as the Netherlands, where some guarantees are mandatory. Last, although performance measurement for the overall ALM may require dynamic tools that are not the industry standard, measuring the performance of individual portfolios — the liability-hedging portfolio and the performance-seeking portfolio — is easy, as standard industry methods are appropriate. The survey shows that 30% of respondents do not assess the suitability of the design of the PSP [performance seeking portfolio], and that more than 50% of respondents use crude outperformance measures. The failure to measure performance may lead to sub-optimal decisions being taken again and again. Samuel Sender is applied research manager at Edhec-Risk Institute ©2011 funds europe

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