As anyone who has ever found themselves in desperate need of a map can attest, getting from point A to point B isn’t always as easy as it should be. The same holds true for pension plans hoping to generate the highest returns possible with the least amount of risk. Though the goal is clear, the best way to reach it isn’t always so apparent– particularly in a marketplace riddled with seemingly endless volatility. For travelers, global positioning satellite systems have helped ease the burden of navigating the unknown. But there is no GPS for investing; and when it comes to managing the risks of an investment portfolio, plan sponsors have yet to find an easy solution.
“First and foremost, you have to define what risk is, because risk is going to have a different meaning depending on your objective,” says Eric Menzer, a managing director with Manulife Asset Management. “In the case of a defined-benefit plan, perhaps risk is defined by your funded status, versus volatility; whereas an endowment may have another objective,” says Menzer, noting that there is a wide range of definitions for risk.
As the saying goes, be careful what you ask for because you just might get it. For institutional investors who have long sought more transparency on the holdings within their portfolios, the amount of information that is now available within the marketplace is more than most of them can even wade through, and it continues to expand.
As part of regulators’ efforts to identify systemic risk, new reporting requirements such as the Securities and Exchange Commission’s Form PF and the Internal Revenue Service’s Foreign Account Tax Compliance Act (FATCA) are forcing money managers to disclose an increasing amount of information about their investment practices, portfolio holdings, and even the investors backing them than ever before. But while these new regulations provide institutional investors with a wealth of information about their investments, managing all this new information is making risk management more difficult than ever.
History often repeats itself. Unfortunately for the investment community, trying to predict when history will repeat itself within the marketplace has been proven to be one of the worst things you can do–a fact that has become crystal clear over the past few years.
The failure of forecasting based on historical market performance has exposed the weakness of quantitative risk management approaches and value at risk measurements (VAR), forcing institutional investors to broaden the way they look at their investment exposure. But as they move beyond traditional portfolio volatility and VAR, many pension plans are discovering that they don’t have the resources needed to adequately oversee all the risks within their investment portfolios or the ability to react quickly enough to changing market conditions. As a result, a rising number of plan sponsors are outsourcing part, and sometimes all, of the daily management and oversight of their investment portfolios.
The days of taking major risks in hopes of even bigger payouts are gone. In their place is a pension industry struggling to determine the best ways to earn enough money to meet their needs but to do so within a low-risk environment. While the dot.com bubble may have faded into the recesses of most institutional investors’ memories, the events of the past few years–from the Madoff scandal to the credit crisis and the multitude of market troubles it revealed–have moved risk management to the forefront of plan sponsors’ concerns. But as obvious as the need for risk control is, there is no one clear investment path for successfully navigating market risks.
“Equity was always the staple asset class, and people were reluctantly dragged into fixed income. And with yields dropping, there was a temptation to wait,” says Martin Lawlor, head of risk management for Prudential Fixed Income. “But that was a mismatch that they needed to correct at some point,” he says, adding that investors who really understand credit have the ability to ensure rates of return–something that cannot be guaranteed through equity investments. The problem is, as pension plans try to address the mismatch in their own portfolios, few of them have a clear idea of how to do so. But one thing most plan sponsors do agree on these days is that short-term measures are useless.