Wednesday, February 24, 2010

Overcoming Fiduciary Fear

There are two kinds of fears that 401(k) plan fiduciaries must overcome in order to effectively manage a prudent investment process .… the fear of doing something and the fear of doing nothing.

Specifically with regard to investment maintenance, fiduciaries often demonstrate a strong reluctance to swap out underperforming investments in an investment lineup. This behavior suggests they feel the risk implicit in changing a plan investment is far higher than maintaining an underperforming investment. Inertia makes maintaining the status quo seems like the risk-less option. Some fiduciaries are simply uncomfortable making decisions on behalf of others.

A countervailing fear, the fear of inaction, is characterized by a compulsion to act immediately when an investment falls below some established performance benchmarks. A mechanistic approach to policy adherence seems procedurally correct to plan fiduciaries, yet taking action too promptly can sometimes generate unnecessary portfolio turnover and detrimentally impact participant portfolios similar to a “buy high, sell low” strategy.

To manage the first fear, plan fiduciaries need to embrace the idea that a good investment portfolio is not static. Changes are inevitable and are required. Fiduciaries need to establish a pattern of investment turnover in order to fulfill their fiduciary responsibilities. The degree and extent of change will vary based on the level and sophistication of plan benchmarking as well as the bias employed in the investment selection process. The closer a plan gets to adopting timeless, consistently executed, and well diversified investment strategies with compatible benchmarks, the less frequently changes will be necessary. The more performance oriented the selection process, the more emphasis put on heroic investment alpha rather than the value of compound investment returns, the more frequently changes will be required. One of the most important skills that differentiate a good portfolio manager and a good fiduciary is the knowledge and ability to “pull the trigger” on meaningful and justified investment changes.

As we saw recently, an excessively mechanistic and pedantic approach to performance based investment changes can backfire on plan fiduciaries who execute their investment policies to the letter. Many good investments underperformed so substantially in 2008 that their longer term performance fell below peers and benchmarks. Strict adherence to standard 3 and 5 year oriented investment policy performance guidelines might have required these investment managers be cut loose…..only to see them outperform by a similarly wide margin in 2009 as the market rebounded. While following investment policy performance standards is a primary rule of prudence, even the best standards won’t always apply to every investment or situation. Prudent judgment is also required. Good investing requires patience, a bit of contrarian sentiment and an acknowledgement that specific facts and circumstances might invalidate general policy rules. Acting in the best interests of participants means making guality decisions not merely following guidelines.

Fiduciaries are required to make investment decisions in the face uncertainty. Avoiding decisions can harm participants and create liability. So can acting without the appropriate deference to current facts and circumstances. Fiduciaries should approach investment decision making with some reluctance…a reluctance borne of patience and careful judgment not one born of fear and lack of information.

Tuesday, February 09, 2010

Leverage Can Reduce Risk ???

That’s the conclusion of the State of Wisconsin Investment Board after it authorized a strategy to lever up its pension plan assets from 4% this year to as much as 20% over the next 3 years. This strategy, generally referred to as “risk parity”, has been used for several years by a number of well known hedge funds, including several which advised the Investment Board.

The essence of a risk parity strategy, which is showing up in public pension board room presentations across the country, is that an expected return rate similar to a traditional 60% equity portfolio could be supported with less volatility by using leverage to boost exposure to lower risk asset classes in a plans asset allocation. Leverage provides a way to ratchet up the returns of the lower risk assets while altering the portfolios risk profile by reducing the proportion of equity risk, the risk that has traditionally dominated most pension portfolios.

While it is not surprising that portfolio risk has taken on a more visible role in asset allocation strategies, it perplexes many that leverage, the proximate cause of the 2008 and other past financial crises, is now the centerpiece of a risk reduction strategy.

The theoretical case for using leverage in a risk parity framework to reduce risk for any given expected return level is sound. It follows the well accepted mean variance, efficient frontier framework that most pension plan sponsors have already accepted as a foundation for their asset allocation decisions. Risk parity simply factors in the ability to borrow at a rate less than or equal to the savings rate. When borrowing is considered, the efficient frontier (the set of portfolios that maximize risk adjusted returns) moves from the concave curve we are all familiar with to a tangent line to the curve originating at the risk free rate. Visually, the equivalent return portfolio on the borrowing frontier has less risk than on the concave frontier

While the risk of higher leverage is dependent on the predictability of the levered risk (in this case fixed income risk is regarded as a much lower risk than equity), the practical case for using leverage may not be as elegant as the theoretical case. Leverage tends to seduce investors because it amplifies investment results. While small amounts of leverage, like the 4% WIB starting position, can’t do irreparable harm, positive outcomes will inevitably lead to overconfidence and higher leverage. Higher leverage will eventually collide with unanticipated market conditions creating the potential for another species of leverage induced portfolio meltdowns.

Just like external leverage in the form of pension obligation bonds was once considered an attractive option for making up public pension under-funding, risk parity is the new way for plans to borrow their way to abundance. It may not turn out to be a bad strategy for all plans but is likely to damage a few as this theoretical free lunch is just too tasty to resist.