The financial crisis and regulatory change have intensified the focus on risk management for a decade. Our participants reflect on the main changes to the risk landscape and how change has impacted long-term portfolios.
Chris Dawson (director, institutional sales, Backstop Solutions)
Scott Eason (partner, head of insurance consulting, Barnett Waddingham)
Rob Booth (director of investment and product development, Now: Pensions)
Martin Kellaway (independent chair of trustees, member of PMI Trustees Group)
Funds Europe – 2019 saw liquidity risk re-emerge as a key topic, one which can have disastrous consequences if not managed appropriately. How do you or your clients approach liquidity risk, and could liquidity ‘fear’ impede asset allocation, returns or diversification?
Rob Booth, Now: Pensions – Auto-enrolment in the defined contribution (DC) pensions world is still relatively young and the current net inflow will continue for a while to come, so liquidity, in the round, isn’t a huge issue for us. On top of that, our portfolios are managed by accessing market indices through derivative products which tend to have inbuilt liquidity. However, we would like to get into illiquid assets – but at £1.5 billion (€1.8 billion), we’d like to be a little bit bigger first.
Chris Dawson, Backstop – From the perspective of our customers, we find that manager selection processes sometimes already incorporate a review of liquidity policies and if they don’t, this is something that is being initiated quickly, which is very reactive given the circumstances and it also raises questions about other types of checks that they should be making. I find that there are some quite complex processes, including liquidity analysis, but there’s also – alarmingly – some quite basic manager selection processes out there.
Martin Kellaway, PMI – From a trustee point of view, we put a fiduciary mandate in nearly two years ago and within that are interest-rate and inflation-rate swaps, and some illiquid assets. Over the past 18 months in the current market conditions, the mandate has performed really well. If we’d stayed with our previous investment strategy, we would have been about 10%-15% down.
Most of our investments are pretty liquid, they’re in unit trusts or assets that can be converted into cash or other assets pretty quickly. But we also have a long-term property fund. It was costly to get into and it’s fairly illiquid. It would be difficult to get out of and in fact recently, the manager has put a 7% exit charge in place. This came out of the blue. We have no intention of getting out of it, but if we did, then it would be quite a big hit for us, including after the 4.5% to get into the fund in the first place. But it’s doing reasonably well.
As part of our strategy we are looking at purchasing some illiquid assets, probably infrastructure via a fund.
I share your worries about analysis that advisers are doing of the underlying investment managers, because it’s incredibly varied. We are happy with the amount of data that we get from our fiduciary manager – but it’s also about faith in that data and where it’s coming from, particularly with ESG, which is real worry for us.
Scott Eason, Barnett Waddingham – In the insurance space, there are essentially three sets of assets. Unit-linked assets have the issues associated with Mr [Neil] Woodford and there’s a lot of work being done to make sure insurance company policyholders have liquidity, because they tend to get out of their policies more often than pension holders.
I think liquidity risk has been overplayed in the annuity and with-profits space as insurers are generally getting more money in than they’re paying out, but on the annuity side, there’s a lot of work being done to make sure that there isn’t too much cash being held for collateral purposes that then impacts returns. There has to be a balance between using derivatives for their liquidity and posting cash as collateral in order to use them.
But in general, liquidity isn’t a major problem for insurance companies. Although the issue centres on illiquid assets not matching liquid liabilities, for annuity funds where there’ll be 50%-60% nowadays in illiquid assets, fundamentally those are buy-and-hold and match liabilities, and with the secondary annuity market having disappeared, insurers don’t have the risk of having to suddenly pay it all out in cash at some point. They’re literally going more and more into illiquid assets because they don’t have the liquid liabilities, but in general insurance – where people do have liquid liabilities – they’re trying to get better returns from illiquids. That’s where I think there’s more of a challenge.
Dawson – Asset managers in this market environment are perhaps being pushed into doing things they wouldn’t normally do because of the pressure of delivering returns. Woodford is a value-based investor and value-driven strategies, in this low interest rate environment, have just not delivered over the last eight or nine years.
Eason – The problem he had was that he changed his strategy without telling anybody, and then everybody went, ‘I’m not happy about that.’ Fundamentally, he was the income provider and then he suddenly started going into these illiquid non-income-providing stocks. I don’t think the problem would have been that Neil Woodford went into illiquid assets had this always been part of his strategy.
Kellaway – You’re right about pressure on investment managers, which is due partly to them being assessed every quarter, every 12 weeks. It’s a short-term pressure but actually, investing is about long-term objectives.
Booth – Master trusts [a new multi-employer pension fund model introduced in the UK] must maintain a wind-up programme, which can be complicated and protracted if illiquid investments are involved.
Eason – Most pension schemes have a prescribed journey where they are thinking about ‘buy outs’ – buying out liabilities in, say, ten years’ time. This means you can’t invest in a 20-year asset. Equity release mortgages is an absolute classic case. Insurance companies who are backing pension liabilities are invested 30% in these assets, but pension schemes generally are not, and we did a lot of work trying to understand why. The answer is because these are 25 to 30-year mortgages, so there’s no guarantee that in ten years’ time they can generate cash.
Although we’ve seen secondary portfolio sales of equity release mortgages, it’s primarily from the banks to the insurers. There are a number of asset managers who have launched equity release funds aimed at pension schemes, but they’ve not really been very successful. It is that secondary piece and how they get out of it that they’ve not quite solved.
An issue with illiquid assets is whether or not you want to go into pooled funds or segregated mandates. Most people want a segregated mandate because they want specific risk profiles – but in the segregated space, you’re generally looking at needing 200 million as a minimum investment. This could be well over 10% of the total portfolio, and that becomes difficult.
Most people want to just ‘tip a toe’ in with maybe 25-50 million, but that’s almost impossible to do on a segregated basis. It’s a big challenge for the medium-sized insurance companies.
Funds Europe – In the 11 years since the collapse of Lehman Brothers and the onset of the financial crisis, investment risk management has been intensely overhauled, both by regulators and by industry best practices; has this changed how long-term investors manage their portfolios?
Booth – The understanding of trustee boards in the DC space has grown as assets have grown and as members have uninterrupted access to the value of their own funds. Trustees can’t take their foot completely off the accelerator, but short-term volatility can be dangerous – if a member can see their pot size drop by, say, 20%, that can scare them off pension saving.
Kellaway – The industry now has the mandatory disclosure of investment manager fees and I insist on a report on fees at the end of each quarterly report. Also, in early December we put in place what’s called an ‘objectives’ for our investment consultant based on a template from the regulator and we added some different aims specifically for our scheme. We’re assessing that on a red/amber/green basis.
There’s also now a mandatory review of fiduciary mandates, meaning three years from now, we’re going to have to go to the market and do a full review of out fiduciary mandate. That’s how it’s changed it from our point of view.
Also, we are more wary of credit ratings. Certainly, when our investment manager recommends assets to us, we ask them to give us some confidence in the rating, and they usually do.
Eason – The major change I’ve seen over the last 11 years has been the fact that you can’t rely on your investment manager as much as you could before. I was a chief investment officer at insurance companies running teams of three or four people. All the big firms have now got 30-40 investment experts reading every line of every bond prospectus and making sure they understand everything.
One of the biggest parts of our business now is fiduciary management oversight. You have to ensure the fiduciary manager is doing the right thing. You have to take ownership and responsibility of everything you’re invested in.
Dawson – The risk process has expanded quite dramatically. Twenty years ago, I was managing portfolios at an investment management house where people though the risk management department was part of the compliance department. Nowadays, risk management departments are vast, almost as big as investment management departments. The process has got deeper and broader. Ten years ago, looking at investment returns versus standard deviation, maybe the Sharpe ratio as well, was probably seen to be enough. The process now even goes down to considering other providers such as distributors, administrators and legal teams.
All this must eat into the margins of the investment managers.
Funds Europe – Does investment risk management have a commonly shared template now, or do processes tend to be tailored to suit particular institutions’ needs? In either case, can you explain your process, relatively?
Dawson – Our clients have quite dramatically different processes, and some are extremely detailed, while others have a lighter approach to the review of their investment managers. I would suggest that in the institutional space, the checks are a lot more detailed. Some places where I’ve seen a lighter approach are in the private wealth area, but even when I go from one pension fund to another, there are very different approaches. But there is also a lot more interest from asset managers who want to know if they are doing what is expected of them, including comparisons to peer groups.
Qualitative analysis of asset managers, which considers the culture of an organisation and underlying operations, is more prevalent. People want to know if risk management is an independent process and if there is a voice at board level raising red flags when needed.
Booth – We now have a director of risk, which we didn’t before. Also, the risk register has been in operation for a long time but has grown in importance and is now pivotal for good scheme governance. In practice, this means understanding the financial strength of the custodian and sub-custodians, understanding all counterparties in the investment chain and actually knocking some off the list because they’re not quite up to scratch or there’s a question mark over them. This approach is used by a lot of master trusts and it’s something that the master trust authorisation process has enhanced.
In a wider context, every supplier has to be closely managed, which is only possible with a thorough understanding of their own processes. Although we’re talking about investment risk management, cyber security and data protection are important issues too.
Kellaway – Dominant fund managers, the big star managers, tend to be quite strong personalities who are difficult to question if you’re working for them, so one of the questions that we’ve raised is, do funds we invest in have this issue?
Booth – This is why we want to see a whistleblowing policy for every supplier, whether it’s a custodian, investment manager, investment adviser. It helps us to assess the fitness and propriety of the people working there.
Kellaway – A factor in this is the size of an organisation. A firm can have a whistleblower process in place but if there’s only a team of six, it’s going to be more difficult blowing the whistle than if you’ve got a team of 60 or 150.
Eason – In the insurance space, there isn’t an off-the-shelf risk package, as far as I am aware. But Solvency II is quite detailed in terms of what a firm has to have in place in terms of risk management of asset investment. Most firms will have done a gap analysis against what they’ve got in their processes and what they get from their asset managers, versus the Solvency II requirements, so most people have something that looks quite similar. There is a minimum level at which firms have to receive data. So, whilst there isn’t a template, most look relatively similar.
Solvency II was a benefit to the insurance industry because of the additional analysis of the investment risks. It enabled people like me who felt there wasn’t very good risk management in certain parts of the industry to have a stick to use. However, the danger is that if there are things insurers should be doing that isn’t in Solvency II, they don’t do it. It gets you to a minimum bar – the question is, does it stop you getting to absolute best practice? There’s a new consultation paper out at the moment on the Prudent Person Principle on Solvency II, that’s expecting you to have more information that we haven’t had historically, such as measuring portfolio volatility, which isn’t a standard activity.
Funds Europe – ESG is possibly one of the biggest changes to have shaped how investors assess risk; how have you implemented ESG factors, and do you feel the benefit has been material?
Kellaway – With effect from October 2019, we have to consider climate change in our investment policy. But what is ESG? Sometimes if you speak to an investment consultant or manager, ESG is an asset class for some of them, while it’s a governance process for others. Also, how you approach ESG will vary depending on scheme size. With 50 million of assets and five trustees, I represent a small scheme, so I suspect that we’ll be using a much simpler, more straightforward ESG assessment process than schemes such as British Telecom.
Unfortunately, there is poor quality of ESG data. It’s no good investing in biofuel assets. It sounds good in an ESG context, but it is not good if they’re clearing 300 acres of prime rainforest in Brazil to grow biofuel crops. We need much better data, much more see-through – and I think from a trustee point of view, frankly, we need more scepticism about it.
Eason – It is a question of if we want to invest in companies with good ESG ratings but actually end up with companies that – although they may have good governance – they are burning huge holes in the world.
We are working with some insurance companies on this. It’s a reputational risk for them. They see ESG as an opportunity and differentiator. However, they’re spending fortunes on models trying to predict what’s going to happen, or looking at the carbon footprinting, whereas a small pension scheme can’t do that.
You have to ask what it is you are trying to achieve with ESG. Is it about reputation? Risk reduction? Is it about trying to enhance returns? There are lots of things you can do with ESG, but even then, it’s difficult to implement and potentially you’re not actually achieving what you want to achieve, because there’s a lot of guesswork involved and some investors are not digging in as deeply as we would like them to.
Kellaway – There’s an issue here from a trustee point of view of retrospective error, where you think you are doing the right thing but ten years down the line, it turns out that the advice you were given was wrong, or it had been improved upon in some way and you missed it, leading possibly to reductions in benefits.
The classic example of this is nothing to do with ESG, it’s about equalisation. Trustees in the UK equalised, or they thought they’d equalised in the 1990s after the Barber Judgment, but when it came to scheme wind-up or they moved legal advisers 20 years down the line, actually they found they had not done it correctly.
Eason – Two years ago, asset managers started making a big noise about ESG but they weren’t doing anything different or new, they were wrapping up their active management process and giving it a new name in an attempt to sell it. They were basically just doing governance – which they should already have been doing. It was all about finding companies with good governance. Well, generally companies with good governance were companies they should have already been invested in.
Dawson – There is one dominant provider of ratings, so I would argue the situation is not dissimilar to what we had with the credit ratings agencies ten years ago. ESG is now becoming such a big part of portfolio management, particularly in Europe. But ESG ratings is an unregulated industry and potentially a problem.
We need more players in terms of data provision, but also less dominant players.
Kellaway – Another issue in the DC pensions world is that if you give members an opportunity to invest in ESG assets, and they do so for 20-40 years, they may find at the end of it that they are 20% or 30% less well off and trustees face legal action.
Booth – That’s a huge point. Trustees have the primary responsibility to get the best return for members, so that overrides everything. At the same time, they have to consider ESG principles. We don’t have to ask members what they think, but we are doing that. We’ve had a few hundred members come back who fundamentally sit on the fence. If you talk about any potential sacrifice of return in exchange for environmental friendliness, just taking one area, they’re not sure whether they want that, which does make life tricky. Also, from our perspective, we often invest through futures contracts and there aren’t many such contracts available with an ESG bias. As we begin to look at climate risk within the portfolio, we’ll explore ways to address that .
We have to explain how we approach our ESG responsibilities in the scheme’s statement of investment principles. So, for instance, in 2017 we replaced some traditional bonds with green bonds as the risk-return characteristics are very similar. That’s wonderful, but we need to look at them regularly to make sure that those characteristics remain the same.
Eason – We’ve done quite a lot of market research that suggests a large proportion of the population would be happy to sacrifice, say, 1% per annum to invest greener. It includes a lot of grandparents who want to leave something good for the younger generation. But it isn’t a one-size-fits-all solution. Providers are going to end up running two funds – one for those who want to invest for a better world, and ones for whom this is not the primary care or who are not persuaded that returns will be favourably comparable.
Funds Europe – Data and technology surrounding investment risk management has grown in recent years, probably exponentially. How do you view this ‘digitalisation’ of investment risk management?
Dawson – Our clients tell me they are finding more and more essential data and technology around risk management. Risk management has so many different connotations such as reputational risk, liquidity risk, obviously investment risk. The point is, there are so many different versions of risk that need to be brought together in some way in order to make processes manageable.
An organisation I know evaluates about 100 managers, 50 of which they are invested in at one time and 50 of which are making up their pipeline of prospective managers. They talked about having many thousands of documents in a file structure where they’re having to look for information, and spending hours and hours because of information overload from an increased risk management process.
Kellaway – This is the reason why we went across to a fiduciary mandate. We were getting a lot of data thrown at us and felt we didn’t really have the capability or knowledge to be able to take all this stuff on board. I’ve been working in pensions for 30-odd years and I struggle with some of this.
Booth – The availability of data has improved over the years. We use a risk parity approach, which means we invest on the basis of risk allocation rather than asset allocation, and to do that it’s important to conduct a lot of modelling and scenario testing within different environments to identify the impact on the portfolio. A key component of this is the relationship between different risks, for instance how your equity risk could impact your bond risk.
Technology allows the manager to really understand how to allocate risk and it is absolutely key to the risk parity approach to investing, so I think in that respect it’s really helped.
We’ve changed our approach from risk classes to risk factors, because it’s important not to consider risks in isolation, but to understand the relationship between different risks and the influence of those risks within any individual asset. That approach really helps the risk parity portfolio to understand where the risk sits and how to allocate on a daily basis.
We use ‘expected shortfall’ to measure risk. On a three-month horizon and running 10,000 scenarios, we ask ‘Okay, what’s the average loss of the 100 worst-case scenarios?’ We have a target expected shortfall figure that is then applied to everything, all parts of the portfolio, so we look at the whole portfolio, then we look at the different risk factors and make sure they all balance out. If rebalancing is needed, it’s our risk allocation that’s rebalanced, rather than our cash allocation.
Dawson – It is necessary to separate data and technology because there are plenty of organisations who will use world-class technology solutions but with a data structure that is inherently very poor. These systems are only as good as the data that you put into them. I think there are a lot of organisations who have gone out thinking that the silver bullet is to buy the best technology provider, but they haven’t addressed the data structures and the challenges around that.
Eason – There has been an improvement in answering ‘What if?’ questions. Ten years ago, I was looking after with-profit and annuity portfolios and we had no idea what exposure we had to asset-backed securities and some of the mortgage-backed securities. What the investment managers do, we can look through it, but on a day-to-day basis, if the financial director came to me and said, ‘What’s our exposure to XYZ Bank?’ because he’d read a bad thing in the press, I couldn’t answer him without digging for the information. Nowadays, the information is there.
Equally, you can then run scenarios, so when something comes out on the regulation of banks and they’re all going to fall 20% in value, you can almost get an instantaneous answer on a scenario.
Funds Europe – Finally, what will define the investment risk management agenda in the following two to three years, at least as far as you’re concerned?
Eason – In the short term, we’re going to be driven by events such as the Neil Woodford problems. In general, the ‘unknown unknowns’ are going to drive us because we don’t know what those events are going to be.
Risk management has always been a little bit backward-looking, unfortunately. Risk managers plug holes that leaked, rather than spotting the ones that are going to leak. But I don’t think there will be any step changes in the next two or three years in terms of how people are managing risk.
Kellaway – I expect the regulator to introduce a fast-track process for approval of valuations and funding regimes. Schemes will either go into this fast-track process, which is based on a series of standardised assumptions that will have to be accepted, or into a bespoke process. The regulator will want to put as many people into this fast-track process as possible. There would be better oversight, but it will create some pressure for standardisation of investment management processes as well.
I think the second thing is consolidation of DB [defined benefit] and DC schemes. Master trust are going to want to standardise processes, particularly on the DB front.
Dawson – First of all, active managers’ margins are under much pressure, so I expect more cost-cutting. There are even outsourced trading desks now because trading desks are very expensive to run. Outsourcing risk management is not inconceivable.
Low interest rates seem to be with us to stay, despite about a year or two ago thinking that we might be getting out of that. Also, ESG will continue to grow.
Then, of course, the elephant in the room that we haven’t mentioned up to now is Brexit. What’s that going to do? Will it lead to a looser regulatory environment?
Booth – I expect the importance of climate risk will continue to grow. I think in the DC space specifically, there’ll be reputational pressure, but there will also be an increasing ambition to do the right thing from the trustees’ perspective. With DC assets growing and growing, members will be more alert to what investments are in their pot and they will be putting pressure on employers, say, to have a climate-friendly provider.
Going back to the start of the conversation, there is also the point of illiquids. I think the amount of money that’s needed for infrastructure projects in the UK and around Europe is enormous. DC assets are also enormous. We’ve always had that issue about liquidity and daily pricing, and these two points contrive to make investment into infrastructure projects less than straightforward. But I think it will get easier, and risk management around it will be something that has to grow.
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