Turning the decision framework on its head establishes the right behaviour
An honest assessment of current decision-making processes show that, more often than not, trustees are sold a solution or a specific fund manager, typically on the strength of that portfolio’s past returns. Or, as we said earlier, they’re drawn to the victor of the last war on the mistaken assumption that the next war will be the same.
The only way to break that suboptimal behaviour is to flip the decision-making process on its head.
A far more effective approach to decision-making in long-term investing is one with a starting premise that asks how much you’re prepared to lose to maximise the likelihood of achieving a realistic return within a defined timeframe. In the real world of investing here are the hard facts: returns in excess of cash can only be achieved by accepting risk. Risk means knowing not just that equities are more risky than bonds but that certain active strategies are more risky than others in terms of their probability for success and the value destruction they can generate if they fail. More importantly, every investment strategy has an embedded cost ‒ even so-called passive strategies. So the real challenge on the trustees’ plate is to develop a framework for weighing four different variables on an on-going basis:
- The probability for success of a given strategy.
- The quantum of potential loss should it fail.
- The cost of employing the strategy, both at the explicit charge level and implicit in the time and resources required for monitoring the strategy.
- The quantum of potential monetary value added should the strategy succeed.
Introducing risk budgeting
What we’ve just described is a conceptual framework known as “Risk budgeting”. Risk budgeting has been around for more than a decade and yet ‒ for a number of reasons ‒ it’s simply failed to become an integral factor in the consulting process or in the investment policy-setting process. To some extent that may be a function of the fact many people simply aren’t sure how to go about it. Additionally, the complex interplay of factors has meant the process requires its own model or decisionmaking tool to get to quantifiable answers.
Whatever the reasons in the past, the reality is that such barriers are increasingly being overcome: the tools are being created and the “guidebooks” for consultants and trustees on how to tackle the problem have been written.
So how does it actually work in practice? What follows is a brief summary of exactly what a board of trustees needs to think about to formulate a risk budget for their fund.
From a pension and provident fund perspective, risks can be categorised as follows1:
- Strategic/policy risk: Trustees rely on an asset and liability modelling exercise that determines the appropriate asset mix for the pension or provident fund serving as the strategic benchmark. The strategic risk of the fund is the risk of poor performance of the strategic benchmark relative to the value of the liabilities ‒ that is, the potential loss that arises when liabilities can’t be met due to underperformance.
- Structural risk: This arises from any mismatch between the aggregate of the portfolio benchmarks and the total fund benchmark. For example, if the actuary modelling the optimal strategic asset allocation for a fund used the ALSI benchmark, and the benchmark for the equity solution in the fund is the median manager in the Alexander Forbes Large Manager Watch survey, there could easily be significant performance variations between the two measures.
- Active risk: The risk the active managers take to achieve their target levels of benchmark outperformance. The underlying style or strategy utilised by the active managers could introduce risk if it leads to underperformance relative to the benchmark. It’s therefore of utmost importance to choose those types of active manager strategies that will, in aggregate, lead to a portfolio robust enough to meet the benchmark over relevant timeframes. Ultimately, the aim is to maximise return per unit of risk from each strategy (eg, value, small caps, growth).
The overall risk for a pension or provident fund is thus the “sum” of the active, structural and strategic risks described and the risk budgeting process entails the efficient allocation of that total fund risk between different sources of value-add.