As asset owners move away from silo-based investment decision making, their performance attribution systems also need to evolve. The Alberta Investment Management Corporation AimCo, the C$70 billion arm’s length investment manager for public sector assets in Alberta, Canada, has implemented a new performance attribution system based on how managers actually make their investment decisions.

 

In an article in the Fall 2014 edition of the Rotman International Journal of Pension Management, authors Jagdeep Singh Baccher, Leo de Bever, Roman Chuyan and Ashby Monk, outline the history of the organisation’s investment performance attribution system, which was essentially a decomposition of the total value added in the prescribed “allocation” and “selection” buckets.

The new decision-based attribution system was designed to mirror the way AimCo actually makes investment decisions.

This includes which agents in the ecosystem are adding value – from the chief investment officer in asset allocation decision making, to the heads of assets classes making decisions about various markets within asset classes, and portfolio managers and analysts making decisions about specific stocks and bonds.

In addition to tactical asset allocation decisions, the new system also considers opportunistic decisions that don’t fit within an asset class.

As outlined in the article, the authors say the new decision-based attribution system has materially improved AimCo’s ability to understand the relationship between investment decisions and investment results.

This is particularly important given that performance attribution should not just explain the past, but be a tool to make better future investment decisions.

 

The full article can be accessed below

Rethinking Investment Performance Attribution

 

Jagdeep Singh Bachher was executive vice-president at AimCo when the article was written, he is now the chief investment officer of the University of California

Leo de Bever is chief executive of AimCo

Roman Chuyan is president and chief investment officer at Model Capital Management

Ashby Monk is executive director of Stanford University’s Global Projects Center

Choosing the appropriate benchmark for active managers is a common debate among institutional investors. Norges Bank Investment Management has produced a “discussion note’ on the benchmark design for an active investment process, in which it introduces a flexible modelling framework that aims to incentivise each portfolio manager to utilise their stock-picking skill.

 

The benchmark design problem that NBIM addresses is not to do with the choice of weighting scheme to arrive at a more efficient beta representation of the market – such as fundamental weighting or risk parity.

Rather the active benchmark design problem it addresses is to construct a suitable custom benchmark on the portion to be carved out from the original market cap index to become the yardstick for the active manager to beat.

The discussion note points out that it could be argued that a cap weighted benchmark is not well suited for an active portfolio manager. One of the drawbacks is the lack of diversification in the index, due to the high concentration of weights in a small number of the largest securities. In a long only context, the NBIM paper, argues that this will generally limit the diversification benefits than enable active portfolio managers to express broader active views across names and size spectrum.

It says the practical implication is to build tailored research lists for the active managers according to their specialisations which form the universe of stocks for the design of the custom benchmark.

The key decisions in the sector benchmark design problem therefore become a choice of the number of names in the research list (universe) and the choice of the weighting scheme that is suitable for the investors’ active investment process.

In broad terms, it says, an optimally diversified sector benchmark should incentivise each portfolio manager to utilise their stock-picking skills and at the same time be able to enhance the fund’s overall performance in a scalable way.

More specifically the sector benchmark design has two defined objectives.

To maximise the potential for outperformance by limiting the number of benchmark names to allow portfolio managers to express high conviction positions while maintaining sufficient coverage of the sector. And secondly to embed diversification in the choice of weighting scheme. This can be achieved by moving away from market cap and towards equal-weighting to allow managers to take on meaningful active positions across their research lists.

 

To access the full research note, click here

Given the capacity constraints on local inflation-linked bond markets, what are other options for hedging long-term inflation-linked liabilities? This is a question Ontario Teachers’ Pension Plan has been deliberating on as it supports an academic chair at EDHEC-Risk Institute with a focus on analysing the design of novel forms of liability-hedging portfolios that do not solely rely on inflation-linked securities. Lionel Martellini and Vincent Milhau from EDHEC discuss the research.

 

Hedging inflation-linked liabilities without inflation-linked bonds

A long-term concern over possible enhanced inflation uncertainty has increased the need for investors to hedge against changes in price levels, a problem of particularly critical importance for pension funds that have pension payments explicitly indexed with respect to changes in consumer price levels.

The implementation of liability-hedging portfolios (or LHP), also known as liability-driven investment portfolios (or LDI portfolios) for inflation-linked liabilities has become relatively straight forward in situations where either cash instruments (inflation-linked bonds, or IL bonds, also known as Treasury Inflation Protected Securities (or TIPS), when the issuer is a sovereign state) or dedicated over-the-counter (OTC) derivatives (such as inflation swaps) can be used to achieve perfect hedging.

More generally, however, the lack of capacity for inflation-linked cash instruments and the increasing concern over counterparty risk for derivatives-based solutions leaves most investors with the presence of non-hedgeable inflation risk.

Another outstanding problem, even when perfect inflation hedging is possible, is that such solutions generate very modest performance given that real returns on inflation-protected securities, negatively impacted by the presence of a significant inflation risk premium, are typically very low.

In this context, the Ontario Teachers’ Pension Plan (OTPP or Teachers’) has been supporting an academic research chair at EDHEC-Risk Institute with a focus on analysing the design of novel forms of liability-hedging portfolios that do not solely rely on inflation-linked securities.

The main research question addressed in the initial stages of the research project was the following: In the presence of capacity constraints on the local inflation-linked bonds market, can one expect a suitably-designed portfolio, potentially involving nominal bonds, foreign inflation-linked bonds and real assets, to be a reliable, and robust across economic regimes, substitute for real bonds in the context of hedging long-term inflation-linked liabilities?

 

Liability risk hedging versus inflation risk hedging

The focus for a pension fund with inflation-indexed liabilities should not be on inflation risk hedging, but on liability risk hedging.

While the two concepts coincide at liability maturity, they do not coincide otherwise because the present value of liabilities is exposed to interest rate risk (unexpected changes in real rates) in addition to inflation risk (unexpected changes in realised inflation).

As clear evidence of this distinction, while long-term IL bonds with corresponding duration are the best liability-matching instruments for IL liabilities, the short-term correlation between changes in inflation and the return on long-term IL bonds is close to zero.

From a quantitative standpoint, our analysis unambiguously shows that for long-term constant maturity inflation-linked liabilities, real rate risk strongly dominates realised inflation risk within liability risk. This is because real rate uncertainty is compounded by time-horizon, while inflation risk uncertainty is not. In other words, unexpected changes in real rates explain an overwhelming fraction of short-term changes in the funding ratio for a pension fund with inflation-linked liabilities. It is only at liability maturity that interest rate risk vanishes and inflation risk remains the only source of uncertainty.

In the end, only IL bonds allow for a perfect match for IL liabilities over both short horizons and long horizons.

 

Expected inflation risk versus realised inflation risk

In a situation where inflation-linked bonds or inflation swaps are not available, at least not at all times and not for the whole inflation exposure, natural substitute candidates would be nominal bonds, since they have well-defined interest rate exposure.

One key concern, however, is that nominal bonds are exposed to changes in nominal rates, as opposed to changes in real rates.

In other words, the value of a nominal bond portfolio is impacted by changes in real rates but also changes in expected inflation, while IL bonds and IL liabilities are only exposed to changes in real rates (and also changes in realised inflation, but this again is not a substantial problem when assessing the short-term risk of long-dated liabilities).

In other words, while realised inflation risk is not a serious problem for long-term constant maturity IL liabilities, expected inflation risk can be because it has no impact on IL liabilities but has a deep impact on nominal bond portfolios that are typically used as substitutes for IL bonds. This is because the expected inflation duration is equal to the real rate duration (and also equal to the standard duration) for nominal bonds, while the expected inflation duration is zero for inflation-linked bonds.

The concern here would be a strong increase in expected inflation, which would lead to a drop in nominal bond prices assuming real rates stay constant, while it would leave liability values unaffected. In fact, the strong positive correlation between realised inflation and expected inflation would imply, everything else being equal, a positive performance of IL liabilities in the case of a positive shock to inflation expectations.

Our historical analysis going back to the ‘60s confirms that a large positive shock to expected inflation has almost always led to a drop in nominal bond prices and an increase in liability values (estimated based on a qualified proxy for expected inflation). In such situations, we have also found that commodities (proxied by the Goldman Sachs Commodity Index or GSCI) have generated strong positive performance most of the time. In this context, one can expect the introduction of real assets in the liability-hedging portfolio to compensate for the poor performance of nominal bonds in the case of a jump in break-even inflation.

One key problem, however, is that while real assets such as commodities may indeed have attractive inflation hedging properties, they have poor interest rate hedging properties, since there is no well defined duration measure for commodities or even for real estate. As a consequence, introducing substantial allocations to real assets in liability-hedging portfolios would generate high volatility in the funding ratio in most market conditions, even though it might help in extreme situations with a high increase in expected inflation. We can summarise the investment policy implications as follows.

 

Diversifying versus hedging expected inflation risk in nominal bond portfolios

In a nutshell, we can look at the problem in this way:

  • Most of the time, nominal bonds would be very good substitutes for inflation-linked bonds, with which they share well-defined real interest rate risk exposure, and they should therefore dominate in liability-hedging portfolios.
  • That nominal bonds cannot be used to hedge the realised inflation risk exposure in IL liabilities is not a quantitatively meaningful problem in terms of short-term volatility of the funding ratio for long-term liabilities.
  • On the other hand, since nominal bonds are exposed to expected inflation risk in addition to real rate risk, while IL liabilities are not, the liability-hedging qualities of nominal bonds would deteriorate in the case of large increases in expected inflation uncertainty, especially when shocks to expected inflation are driven by factors that are not related to interest rate risk.

 

From a conceptual perspective, two main approaches can be used to manage this risk of mismatch between the non-zero exposure of nominal bonds to changes in expected inflation and the zero exposure of inflation-linked bonds to the same risk factor.

  • Focus on diversifying away expected inflation risk

The strategy here would consist in holding at all times a dynamic mix of the liability-hedging portfolio that is optimal under different particular regimes (i.e., with more real assets or less), where the weights assigned to each liability-hedging portfolio at any point in time are taken to be a function of the estimated probability of being in each regime.

 

This dynamic diversification strategy contrasts with a static diversification strategy, where a static mix of the hedging portfolios that are optimal under each particular regime, which would involve holding too much of the real assets in the high expected inflation regime, and too little otherwise.

  • Focus on hedging away expected inflation risk

While a long-only position in nominal bonds will always have a negative exposure to unexpected inflation, long-short nominal-bond portfolio strategies can in principle be designed to achieve zero exposure to changes in unexpected inflation, while having a target exposure to changes in real rates equal to that of the liabilities. What remains to be thoroughly analysed is whether this strategy can be effectively implemented in practice. In particular, one needs to carefully assess the out-of-sample robustness of quantitative strategies based on imperfect parameter estimates that may suffer from sample risk.

 

Diversifying expected inflation risk in nominal bond portfolios

For the diversification of expected inflation risk we find the following:

 

  • While realised and expected inflation risks have been relatively limited in the recent past in developed economies, a long-term analysis suggests that the presence of possible regime switches needs to be taken into account. A formal statistical analysis confirms that regimes with high expected inflation and low speed of mean-reversion in expected inflation would lead to a profound mismatch between long-only nominal bond performance and liability returns.
  • Given that our analysis has confirmed that real assets in general, and commodities in particular, have been formally verified to perform well in the case of large positive shocks to expected inflation, in particular when these shocks are driven by increases in commodity prices, substantial benefits can be generated from a strategy dynamically weighting a nominal bond-dominated liability-hedging portfolio and a real asset-dominated nominal bond portfolio as a function of the probability to stay in the normal regime versus entering a high expected inflation regime.
  • The benefits of such a strategy are robust with respect to the introduction of a realistic lag in terms of recognising the emergence of the high expected inflation regime. This finding is particularly important because the real-time identification of regime switches is a serious statistical challenge. In particular, formal Markov regime switching models would typically identify periods of increasing inflation risk, without distinguishing clearly between increases and decreases in expected inflation, and simpler, more robust approaches would therefore be recommended.
  • In addition to substantial levels of turnover generated by the switch from a bond-dominated to a commodity-dominated liability-hedging portfolio, the strategy involves holding a liability-hedging portfolio with little or no fixed-income instruments in high expected inflation regimes, which is not only at odds with standard practice but also can prove a serious problem in the case of a substantial drop in real rates.

 

Hedging expected inflation risk in nominal bond portfolios

On hedging expected inflation risk, our findings can be summarised as follows:

 

  • Liability risk management is about matching risk exposures of assets and liabilities. Real rate exposure (also known as real rate duration) can be explicitly measured for bonds as a function of observable variables, while it has to be empirically estimated for real assets, and can therefore be made to match the real rate exposure in the liabilities.
  • On the other hand, the exposure of inflation-linked liabilities to expected inflation is zero, and therefore it should also be neutralised on the asset side to avoid introducing an ALM mismatch. While a long-only position in nominal bonds will always have a negative exposure to unexpected inflation, long-short nominal-bond portfolio strategies can in principle be designed to achieve zero exposure to changes in unexpected inflation, while having a target exposure to changes in real rates equal to that of the liabilities.
  • In principle, a suitably-designed long/short nominal bond portfolio would have a substantially lower (if not zero) exposure to shocks to expected inflation compared to a standard long-only bond position, while allowing for an exposure to real rate risk targeted to be similar to that of the liabilities.
  • The long duration bond has a higher sensitivity to changes in expected inflation but changes in expected inflation are less volatile for the long term; conversely, the short duration bond has a lower sensitivity to changes in expected inflation but changes in expected inflation are more volatile for the short-term. The suitable dynamic hedging strategy emerges from the quantitative analysis of this trade-off.
  • In the presence of uncertainty about speed of mean reversion parameter estimates, our analysis suggest that a robust implementation of this strategy can generate substantial benefits, if not allowing for a perfect hedge, a conclusion which is supported by a detailed statistical analysis of the dynamics of the term structure of expected inflation.

 

Policy implications

Three main policy implications can be drawn from our research:

 

  • Policy implication #1: A static exposure to commodity (more generally real assets) in the liability-hedging portfolio would not be a good solution; whatever the exposure, it would be too high most of the time, in normal regimes where the poor interest rate hedging properties of real assets would generate substantial short-term funding ratio volatility, and too low in those rare market conditions with extreme increases in expected inflation.
  • Policy implication #2: A dynamic exposure to commodity (more generally real assets) in the liability-hedging portfolio would be a reasonable approach to diversifying away the risk of a large positive shock to expected inflation. Using a parsimonious model based on an observable, persistent, state variable such as expected inflation, one would be able to switch, even with some reasonable delay, from a bonds-dominated liability-hedging portfolio to a commodities-dominated liability-hedging portfolio in the case of a strong increase in the likelihood of a regime with high expected inflation.
  • Policy implication #3: A duration matching strategy involving long-short allocation to nominal bonds of different maturities would be a reasonable approach to hedging away the risk of a large positive shock to expected inflation. Aiming at setting to zero the exposure of the bond portfolio to expected inflation requires parameter estimates that tend to be noisy, a robust implementation of the strategy can be performed, based on the finding that changes in expected inflation are consistently larger in absolute values for short maturities versus long maturities.

 

 

Lionel Martellini, professor of finance, EDHEC Business School, scientific director, EDHEC-Risk Institute

Vincent Milhau, deputy scientific director, EDHEC-Risk Institute

New research by MSCI shows a rare insight into whether the factor phenomenon, driving development market equities beta, is at play in emerging markets. The research uses the Barra Emerging Markets Equity Model to look at the drivers of performance of emerging markets, and analyses the returns of active emerging market managers to identify the factors they have exploited. The research reveals some interesting results.

The paper, “Factoring” in the Emerging Markets Premium, seeks to uncover the performance for factor indexes in emerging markets.

It also asks whether significant emerging markets factor premia are a recent phenomenon, whether emerging markets active managers are exploiting all of the opportunities presented by these factor premia, and whether there are ways that active emerging markets managers can capture additional factor premia.

As with developed markets, the research finds, that a significant portion of active manager returns can be attributed to emerging markets beta. High dividend yield and momentum factors were also significant contributors, suggesting that active emerging market managers have been harvesting systemic factors in their investment process.

Other premia factors such as value, low size, quality and low volatility that have demonstrated outperformance over the broader market did not appear to be significant drivers of active emerging markets managers’ returns, suggesting that these factors offer interesting opportunities as complementary investment strategies.

 

 

There is a lot more work to do in raising the quality of governance of pension boards around the world, Keith Ambachtsheer told a conference of Australian superannuation fund trustees and staff last week.

“We have to stop thinking about organisational needs and think about member needs. The business model must invert from serving organisational needs to serving member needs. That is the mission of the business and you should not forget it. It is not about achieving market share, it is not about having the highest returns in the league tables,” he told delegates at the Australian Superannuation Fund Association conference in Melbourne.

“To do that requires strong governance. A good board is able to ask the right strategic questions. They have to ask what they are doing to reach their goals.”

Ambachtsheer, who is president and founder of KPA Advisory Services and director emeritus of the Rotman International Centre for Pension Management,  says an effective board requires people who are both publicly minded and have the collective requisite skill and experience to do the job.

Ambachtsheer cited a periodic survey of 80 pension fund organisations which were asked to rank themselves by 23 different metrics in 1997, 2005 and 2014. In all three surveys board selection process ranked low, he said.

“Some of the comments received from funds who answered the survey were that ‘The board selection process for our organisation is seriously flawed’, and ‘we have a wonderfully dedicated board, but they fly just above the tree tops rather than at a strategic fiduciary altitude’.

“Clearly the message is that we are not done yet in raising the quality of governance of pension boards around the world. There is more work to be done,” Ambachtsheer said.

Ambachthseer reiterated that the more funds know about their members the better they can meet their needs.

“Funds should build a database on member facts and attitudes. They should provide members with pension targets and investment plans on how to get there and then provide regular progress reports towards targets, and they need to develop longevity insurance options for the decumulation phase. All this will create a strong connection between an organisation and its membership,” he said.

“If we have certain goals to achieve for our members through income replacement or the ability to maintain their standard of living, that should become a central focus for organisational success. You also need to think about the investment and members services’ program. Are we giving value for money? We need more feedback loops,” he said.

 

Ambachtsheer began his presentation quoting from Peter Drucker’s 1976 book “The Unseen Revolution”, whereby Drucker listed six metrics, which Ambachtsheer believes are still relevant to be a good performing fund today:

1 Mission clarity

2 strong governance

3 strong member interface and interaction with the members

4 sensible investment beliefs

5 competitive compensation for its own professionals

6 strong feedback loops.

“I believe those are the key performance metrics, the six key success metrics. We are getting better over time, but we have got a long way to go,” he said.

In terms of sensible investment beliefs, Ambachtsheer gave delegates a guide or starting set of beliefs:

  • We articulate a clear investment stance and live it
  • We have separate programs for long term wealth creation and providing short term payment safety
  • Our long term wealth creation program invests in real businesses
  • Our primary asset is human capital
  • We balance conviction and humility.

Ambachtsheer estimates, very roughly, that there is probably 75 basis points of savings if funds followed this five points.

The barriers to success, he says, include sensitivity to short term peer relative performance, an inability to insource high cost investment programs, and an inability to create success metrics for long term wealth creation programs.

“There needs to be a set of metrics where the board can say how the long term investment program is doing,” he said.

 

 

 

 

For Scott Powers, president and chief executive of State Street Global Advisors, assets under management is not a measure of success – the manager is currently the world’s fourth largest with around $2.5 trillion. Instead it is the ability to provide value for clients in meeting their objectives – whether it be matching liabilities, creating alpha or educating plans on defined contribution models – that keeps Powers striving for excellence and innovation and a more outcomes-oriented environment.

State Street Global Advisors’ heritage dates back over two centuries. It is one of the world’s largest asset managers, employing more than 2,400 people across offices in 16 countries, managing assets of $2.5 trillion. It’s somewhat of a behemoth.

On the surface this would suggest it’s not set up for innovation, or nimble reaction to clients’ needs. But under Scott Powers, SSgA continues to innovate and create a solutions-driven, client-focused environment.

Powers talks at a million miles an hour. He’s articulate and passionate and his story flows off the tongue easily.

His team of more than 400 investment professionals manages investments across the full spectrum – from traditional beta, through advance beta to concentrated portfolios and hedge funds.

The manager’s investment philosophy is underpinned by its values of excellence in research, collaboration, accountability, and innovation.

Advanced beta is an example of an area where research underpins the manager’s product development, where recent recruit Dr Jennifer Bender, formerly of MSCI, leads the research charge.

“We are building a formidable array of advanced beta,” Powers says, very deliberately using the word “advanced” not “smart” beta, as a tribute to the traditional cap-weighted beta which he describes as being in no-way dumb.

“This includes equal-weighted, GDP-weighted, fundamental including size, value, growth momentum, and we are doing active modelling with the combinations of all of those, and have a number of clients looking at that.”

Powers sees the development of advanced beta as having no negative effect on the passive business, but it is a real opportunity to take allocations from active managers which are not delivering active returns net of fees.

“Put it this way, I started my career in a large cap value shop, we were charging 70 basis points for products based on size, volatility and valuation. Now SSgA can deliver that in a systematic rebalanced way for 5 basis points over the index,” he says. “If you’re looking at return after fees and believe in factors, then we can do it cheaply.”

While SSgA can deliver advanced beta in a systematic passive manner, he says clients still need to remember that it is an active decision and that includes determining the pain threshold for underperformance.

“It’s the same decision in choosing an active manager, you have to stay the course.”

 

As the relationships between asset owners and managers evolve, managers need to adapt their offerings. The traditional relationship, which is dependent on a strategy or return stream, is still important but is not the only way of interacting with clients, and possibly not the most effective or sustainable.

Powers is cognisant of this and is conscious of the advantage that SSgA’s size and breadth of offerings brings to customisation.

“We look at the bigger picture of what clients objectives are, whether it is GDP plus 5, hedging tail risk, managing liabilities, or educating defined contribution participants on their savings levels. This has led to more focused conversation, which is outcome oriented, and we can customise strategies to the discrete needs of clients,” he says.

SSgA has offerings across equity, fixed income, currency, real estate and absolute return, covering the spectrum of investment approaches, including indexed, enhanced and active; and a range of vehicles from private funds, commingled investment vehicles, ETFs, mutual funds and client-directed mandates.

“We are having conversations at a more strategic level. For example we manage relationships with heads of HR and the CIO at corporate funds, and do a lot of work about retirement readiness at the individual level with their members. Partnering with the HR departments of clients to understand the individuals is not just corporate funds, but defined contribution funds like the NEST in the UK,” he says.

As a result of this more strategic level, rather than an asset class, conversation, SSgA has built its own investment solutions group which now has about $200 billion and 70 investment professionals.

“We don’t manage an asset class but an overall solution, it is less benchmark related and more absolute return,” Powers says. “We still have specialist relationships, which are predominant, but for those willing to engage at a different level we are holistic. We ask clients what is your objective and how do we help?”

Of course the answers to all those questions are unique, as all clients are unique, so the packaging and scaling of those solutions, a funds management business staple, is complicated.

“Clients have a variety of risk targets, and their willingness to bare risk can guide the conversation of our solutions. Those clients are all unique so the solutions are client centric and packaging and scaling of that is difficult.”

However the intermediary clients of SSgA are, mostly, using ETFs or funds which are more packaged solutions, and the manager is taking the conversations it has with institutions and synthesising those to a single pool that’s scalable on a targeted basis.

“Then that can be employed at an adviser level or for smaller clients, for the efficient deployment of strategies. It’s not about the best equities fund, but solutions at a multi-asset class level.”

Powers sees this intermediary level as one of three prongs to the manager’s growth.

“I think our growth is with traditional institutions – particularly sovereign wealth funds. These are clients with sophisticated needs and we’re well positioned to serve them. It’s with defined contribution funds globally, and the importance for nation states to meet retirement needs. And thirdly it’s with financial advisers which make up about 25 per cent of the investable universe globally.”

For all of these clients, it’s not about products but about helping clients solve their problems and meet their objectives. Increasingly this is customised via multiple building blocks.

“We care about helping clients solve their problems and meet their objectives, what does it mean for them, and how do clients’ value that?”