Risk reporting is increasingly regarded by sophisticated investors as an important ingredient in their decision-making process, authors from EDHEC argue that  the effective number of (uncorrelated) bets could be a useful risk indicator to be added to risk reports for equity and policy portfolios.

Risk reporting is increasingly regarded by sophisticated investors as an important ingredient in their decision-making process.

The most commonly used risk measures such as volatility (a measure of average risk), value-at-risk (a measure of extreme risk) or tracking error (a measure of relative risk), however, are typically backward-looking risk measures computed over one historical scenario.

As a result, they provide very little information, if any, regarding the possible causes of portfolio riskiness and the probability of a severe outcome in the future, and their usefulness in a decision-making context remains limited.

For example, an extremely risky portfolio such as a leveraged long position in far out-of-the-money put options may well appear extremely safe in terms of the historical values of these risk measures, that is until a severe market correction takes place.

This was pointed out by Andrew Ang, William Goetzmann, and Stephen Schaefer in their 2009 report to the Norwegian Ministry of Finance “Evaluation of Active Management of the Norwegian Government Pension Fund–Global”.

In this context, it is of critical importance for investors and asset managers to be able to rely on more forward-looking estimates of loss potential for their portfolios.

In recent research produced with the support of CACEIS as part of the research chair at EDHEC-Risk Institute on “New Frontiers in Risk Assessment and Performance Reporting,” we focused on analysing meaningful measures of how well, or poorly, diversified a portfolio is, exploring the implication in terms of advanced risk reporting techniques, and assessing whether a relationship exists between a suitable measure of the degree of diversification of a portfolio and its performance in various market conditions.

While the benefits of diversification are intuitively clear, the proverbial recommendation of “spreading eggs across many different baskets” is relatively vague, and what exactly a well-diversified portfolio is remains somewhat ambiguous in the absence of a formal quantitative framework for analysing such questions.

Fortunately, recent advances in financial engineering have paved the way for a better understanding of the true meaning of diversification.

In particular, academic research has highlighted that risk and allocation decisions could be best expressed in terms of rewarded risk factors, as opposed to standard asset class decompositions, which can be somewhat arbitrary.

For example, convertible bond returns are subject to equity risk, volatility risk, interest rate risk and credit risk. As a consequence, analysing the optimal allocation to such hybrid securities as part of a broad bond portfolio is not likely to lead to particularly useful insights.

Conversely, a seemingly well-diversified allocation to many asset classes that essentially load on the same risk factor (e.g., equity risk) can eventually generate a portfolio with very concentrated risk exposure.

More generally, given that security and asset class returns can be explained by their exposure to pervasive systematic risk factors, looking through the asset class decomposition level to focus on the underlying factor decomposition level appears to be a perfectly legitimate approach, which is also supported by standard asset pricing models such as the intertemporal CAPM or the arbitrage theory of capital asset pricing.

Two main benefits can be expected from shifting to a representation expressed in terms of risk factors, as opposed to asset classes.

On the one hand, allocating to risk factors may provide a cheaper, as well as more liquid and transparent, access to underlying sources of returns in markets where the value added by existing active investment vehicles has been put in question.

For example, the argument in favour of replicating mutual fund returns with suitably designed portfolios of factor exposures such as the value, small cap and momentum factors.

Similar arguments have been made for private equity and real estate funds, for example. On the other hand, allocating to risk factors should provide a better risk management mechanism, in that it allows investors to achieve an ex-ante control of the factor exposure of their portfolios, as opposed to merely relying on ex-post measures of such exposures.

In our research, we first review a number of weight-based measures of (naive) diversification as well as risk-based measures of (scientific) diversification that have been introduced in the academic and practitioner literature, and analyse the shortcomings associated with these measures.

We then argue that the effective number of (uncorrelated) bets (ENB), formally defined in Managing diversification as the dispersion of the factor exposure distribution, provides a more meaningful assessment of how well-balanced an investor’s dollar (egg) allocation to various baskets (factors) is.

We also provide an empirical illustration of the usefulness of this measure for intra-class and inter-class diversification. For intra-class diversification, we cast the empirical analysis in the context of various popular equity indices, with a particular emphasis on the S&P 500 index.

For interclass diversification, we analyse policy portfolios for two sets of pension funds, the first set being a large sample of the 1,000 largest US pension funds and the second set being a small sample of the world’s 10 largest pension funds.

In a first application to international equity indices, we use the minimal linear torsion approach to turn correlated constituents into uncorrelated factors, and find statistical evidence of a positive (negative) time-series and cross-sectional relationship between the ENB risk diversification measure and performance in bear (bull) markets.

We find a weaker relationship when using other diversification measures such as the effective number of constituents (ENC), thus confirming the relevance of the effective number of bets on uncorrelated risk factors as a meaningful measure of diversification.

Finally, we find the predictive power of the effective number of bets diversification measure for equity market performance to be statistically and economically significant, comparable to predictive power of the dividend yield for example, with an explanatory power that increases with the holding period.

In a second application to US pension fund policy portfolios, we find that better diversified policy portfolios, in the sense of a higher number of uncorrelated bets, tend to perform better on average in bear markets, even though top performers are, as expected, policy portfolios that are highly concentrated in the best performing asset class for the sample period under consideration.

Overall, our results suggest that the effective number of (uncorrelated) bets could be a useful risk indicator to be added to risk reports for equity and policy portfolios.

 

*Lionel Martellini is professor of finance at EDHEC Business School, and scientific director at EDHEC-Risk Institute

Romain Deguest, senior research engineer, EDHEC-Risk Institute

Tiffanie Carli, research Assistant, EDHEC-Risk Institute

 

The research from which this article was drawn was supported by CACEIS as part of the “New Frontiers in Risk Assessment and Performance Reporting” research chair at EDHEC-Risk Institute.

The risk of a US equity market decline and concerns over the future direction of interest rates has been driving US foundations and endowments’ asset allocation decisions in the past year, with a distinct move away from US equity to global allocations and away from US-focused core to longer duration and high yield.

The latest investor trends report from eVestment shows the US foundation and endowment universe to be moving assets out of their largest allocations of US large cap value, core fixed income, large cap growth, interim duration fixed income and core plus fixed income.

As a result of the low-yield environment, these investors are increasing allocations towards cost-effective, passive, global equity exposures and higher-yield and longer duration fixed income. According to the eVestment report, in changing from low and interim duration US fixed income, these investors have allocated to funds which have been increasing their cash positions, reducing their yield to maturity, but also increasing average weighted coupon, portfolio maturity and duration.

Further these investors are favouring strategies that have shifted their portfolios away from AAA to BBB.

“In order to maintain a certain level of yield, they have been forced to move out on the credit spectrum. This is generally true for any non-alternative strategies that have operated with specific return expectations,” the report says.

It also says that allocations to the hedge funds industry have accelerated over the last three quarters.

Throughout 2013 there were large inflows to credit and multi-strategy funds and entering 2014 investors have heavily increased allocations to long/short equity and event driven strategies, all of which appear to be at the expense of manage futures and macro strategies.

“With multiple surveys illustrating interest in hedge funds, private equity and real assets, along with what have been large aggregate flows into alternative credit strategies, foundations and endowments have been active in searching for new sources of yield and return credit markets while also attempting to reduce exposure to directional movements in rate markets.

In the coming weeks, Towers Watson will be writing a series of articles, exclusive to conexust1f.flywheelstaging.com, that look at key challenges facing large asset owners. These will focus on specific practicalities that many global funds are encountering such as the role of internal teams.

To put these challenges in context, this first article by global head of content, Roger Urwin, explores six overarching issues that Towers Watson believe will shape the investment landscape for the world’s large asset owners in the coming years.

 

Thomas Piketty’s study of wealth is receiving intense attention, but little has been said about the new place of the world’s big asset owners. The biggest 100 such funds (let’s call them the ‘biggies’) make a fascinating group and carry critical significance for our future. At the start of 2014, these funds had assets amounting to over $15 trillion, and titles to wealth for a significant proportion of the whole planet.

In previous eras these funds have tended to use a core investment strategy, such as 60 per cent equities and 40 per cent bonds to transfer wealth over time. Making a decade-long projection of this strategy starting with current values one would expect returns of around 3 per cent per annum in real terms.

The ‘r’ of return on capital being higher than the ‘g’ of global economic growth is the most significant mathematics from the Piketty book. While in previous decades the asset owner ‘r’ was normally around 5 per cent per annum and economic growth was around 3 per cent, the current era makes that norm doubtful. The ‘r’ of the simple 60/40 strategy may not exceed the ‘g’.

 

This produces the first issue facing the biggies.

The pension funds in the list – around 80 of the 100 – have defined liabilities to meet, and their solvency is premised on achieving returns exceeding global growth.

The sovereign wealth funds in the list – the remaining 20 or so – aim to grow wealth for a future generation at a rate above world economic growth rate.

A real return of 3 per cent per annum is not sufficient to meet these requirements either. So it is no surprise that the strategies of both groups are evolving.

More significant investment in alternative asset classes like real estate, private equity and infrastructure is one consequence. In addition, there has been the growth of alternative strategies such as factor investing and other smart betas. These require investment skill from the asset owner entity itself rather than from outside investment firms.

 

Issue two for these funds, therefore, is their organisational design and investment governance to adopt these strategies successfully and achieve their desired results.

The early structure of asset owners involved heavy reliance on their boards and investment committees, which, in turn, relied on external investment mandates.

The biggies increasingly see the development of in-house capabilities as necessary; in the ‘war for talent’ endemic to financial service organisations, they have had to secure key ‘C-suite’ positions: chief executive officer, chief investment officer, chief operation officer and chief risk officer, for example. In building the skill of asset owners, leadership roles are critical.

For organisations used to running small operations, this expansion carries significant opportunities and challenges.

The asset owner must create a highly skilled organisation that has strong culture and leadership; is driven by human-capital practices that attract and retain talent; operates with clear responsibilities and accountabilities; and creates motivational energy through performance management and personal development.

It is hard to understate the significance of this step for funds that need to quickly build the qualities that their asset manager counterparts have developed over the past half century. It is fair to say this is work in progress.

 

Issue three is the adjacent point of how to develop successful private market strategies.

The biggies must extend their reach into private markets beyond the equity and bond public markets to achieve their target returns.

Such an extension to strategy can add to return, in part because of the leverage employed in these markets, but need not change the overall risk exposures.

The biggies’ exposure to private markets now averages around 20 per cent, up from 5 per cent around the turn of this century. These funds are now seeking to settle the level at which allocations should stabilise and which of the private equity, real estate, and absolute return sets should be included.

Funds have not found this change of strategy simple to implement in terms of the optimum blend of internal and external management, leading to issue four.

 

Early implementation involved heavy reliance on outside expert investment firms. A combination of very high costs and complexity in oversight of these mandates has prompted the biggies to consider in-house alternatives. The challenge is how this internalisation of investing can be accomplished.

Many funds in this situation have come to resemble big complex investment institutions. Examples of this specialisation can be found at funds like CPP where, for example, private market resources have developed into three figure teams, enabling the range of activities to include direct and co-investment deals. But the benefits of specialisation come with issues of maintaining coherence and control.

Some funds have fought against creating asset class specific silos. The organisational design that keeps the team together on all decisions is often referred to as the one portfolio approach. In this approach each investment idea is considered as a contest for capital against all other ideas, with comparisons on a risk-adjusted basis.

Specialists join with investment leadership colleagues to make the go/ no go determination instead of being asked to fill a pre-agreed strategic allocation. Examples of organisations preferring this approach include the likes of Future Fund Australia and New Zealand Superannuation Fund.

The allocation process itself has attracted innovation.

New methods increasingly frame the process in risk allocation terms, deriving overall portfolios that best balance risk factors.

 

This introduces our issue five. This development has made funds diverge in their strategies as their segmentations differ and they reflect different underlying beliefs.

A notable example of the divergence appears in exposures to investment factors and themes often referred to as smart betas.

The narrow version of smart betas involves systematic exposures to factors such as value, momentum and small cap. The wider version considers those themes where structural mispricing may exist. Examples include themes positioned around the emerging growth markets and longer-term change in resources, the environment and demography.

The control of factors suggests a shift of responsibility, at least partially, from the external manager to an internal team.

The biggies vary widely in their reliance on external firms, but almost all use them to produce skill-based returns (‘alpha’).

The nature of these relationships has shifted, reflecting better appreciation of the value proposition that mandates and external firms can demonstrate.

 

Issue six then is the effective management of alpha derived from fusing internal skills to the external marketplace.

The more successful examples of alpha generation seem to come from mandates that are lightly benchmarked, institutionalise longer-time horizons, and embed wider knowledge transfer.

 

The biggies have to think hard about how to compete successfully. Asset owners in most cases have access to permanent capital. Their competition is not for capital but for talent and returns.

Their future progress will be determined by their competitive response to these six issues: the investment goal itself; organisational design and governance; private market investing; internalisation; capital allocation and smart beta investing; and alpha.

The common thread through all these six factors is the degree of change and greater skill needed to bridge the gap between the bulk beta returns and these organisations’ needs and aspirations.

 

By Roger Urwin, global head of investment content at Towers Watson

 

This paper by the Becker Friedman Institute for Research in Economics at the University of Chicago finds that the active management industry has become more skilled over time. But despite this rise in skill, average fund performance has failed to improve.

To access the paper click below

Scale and skill in active management

 

Pension fund boards are complex, evolving, collective bodies and the individuals that serve them face unique challenges. The Rotman-ICPM Board Effectiveness Program is a week-long course designed specifically for pension fund trustees that showcases how an effective board looks and behaves.

Pension management beneficiaries are delegating to a body that then delegates to an executive, it is a consensus body that is unique in design and function.

The role of, and skills required of trustees and the collective board is constantly evolving, and to be effective requires training and evaluation.

On four occasions the International Centre for Pension Management at the Rotman School of Management at the University of Toronto, has brought together 128 participants from 52 pension organisations and 11 countries for its “Board Effectiveness Program”.

The course, which is held over a week-long period guides trustees through courses on organisation mission, fiduciary duties, board dynamics, role of the board versus management, investment beliefs, risk management, organisation design and HR management and compensation.

They are asked to do role play exercising board dynamics with a particular case study dealing with the issue of incomplete information.

“We give delegates a problem to solve but not everyone gets the information. The only way to solve the problem is by sharing the information,” Ambachtsheer says. “It’s a shocker, most groups fail.”

Critically, through case studies and exercise, it equips graduates with an integrated framework to critically examine how these issues are all linked together.

Keith Ambachtsheer, who is the director emeritus of the Rotman International Centre for Pension Management and academic director of the course, says one of the key differentials in the Rotman School’s offering is it is “deliberately strategic” and not just reciting facts.

“We look at case studies and exercises on how to implement the reasonable judgment rule. What does success look like and how do you measure it?” he says.

One of the reasons this training is so important now, Ambachtsheer says, is the evolving nature of fiduciary duty.

“But now rather than a cooker cutter fiduciary duty it is a “reasonable expectations” standard, it is contextual,” he says.

“Boards need to understand the nature of the agreement, who’s contracting who to do what, not just about the here and now but future parties, so how do you do that?”

At the Rotman-ICPM Board Effectiveness Program, participants get to learn from doing.

Ambachtsheer says one of the more interesting exercises is an assignment whereby the chair of a fictitious dysfunctional board asks participants to help fix the board.

“It gets you into the question of why the board is dysfunctional,” he says.

It also raises the element of representation and the idealism of trustees and who they are representing.

“Representation is ok up to a point, boards need to be seen to be legitimate,” he says. “But there is an “and and” as well. It is not enough there also needs to be a collective skill and experience in the requisite skills.”

Ambachtsheer advocates the skill/experience matrix as an easy practical tool to assemble and manage a board.

“If the board needs to make decisions in these areas – it might be strategic decisions, audit experience, risk management, HR function – then what is the skill set that is needed to do that,” he says.

Interestingly, Ambachtsheer believes it is best practice for the entire board to be the investment committee, and points to organisations such as Ontario Teachers’ Pension Plan where this is the case.

“This means you need people on the board who can play a role, they are not experts but need to ask the hard questions.”

Drawing from the Peter Drucker management philosophy, Ambachtsheer believes that one of the key roles and responsibilities of a board is to hire and assess the chief executive.

“You don’t do their job but a board finds and evaluates the chief executive, and holds them to account.”

Ambachtsheer believes the best tenure for a board member is three terms of three-years, and that this ensures not only that an individual’s skills are evolving but the board as a collective is evolving.

“Nothing is forever,” he says. “This structure is long enough to get to know the organisation but know there’s an end. We had a governance committee that was working on who’s leaving and what we were losing when they left.”

While measuring good governance, decision making and delegation may very well be the holy grail in pension management, it is hard to quantify.

“I’ll know it when I see it,” he says.

However Ambachtsheer can say that a functional board will have passion for the cause, collective skill, a diversity matrix which by definition includes behaviour, and a blend between being collegial and individual integrity.

Ambachtsheer is currently working on the third global board effectiveness survey, which measures the responses of pension fund executives to their board’s functionality.

The survey was done in 1997, 2004 and will be initiated later this year, asking a series of statements to reflect the function or dysfunction of the organisation.

Rigorous Environmental, Social and Governance (ESG) management can deliver an extra 40 basis points per month according to Saker Nusseibeh, CEO and head of investment at Hermes Fund Managers.

“Where it [ESG] really matters for performance is in consistently avoiding bad governance. You can add 40 basis points per month… Per month!” Nusseibeh told a crowd of Australia’s top 50 superannuation funds and asset consultants at the Conexus Financial Australian Fiduciary Investors Symposium last week.

Nusseibeh talked about the importance of weighing up a company’s sustainability when considering whether to hold it in portfolios. Governance issues, he said, should be a mandatory part of the process, while environmental and social issues also weigh heavily despite being harder to measure.

“Think in terms of its ability to consistently offer stable returns for over 20 years, because that’s the investment time frames of your members. That’s how long they can be invested for, not one, two, or three years,” he said.

“Look at Lloyds of London. It successfully insured against world events for over 200 years… Then it went belly up, not because they couldn’t calculate risk. They were pretty good at that, but they didn’t successfully calculate the environmental risk of asbestos.”

Nusseibeh also urged trustees and managers to think more broadly about the future implications for fund members in a world devoid of ESG; one of lower standards of living punctuated by greater wealth inequality; high inflation; and transport and fuel restrictions.

“ESG is a tool for enhancing returns… But one should also do what is right for the sake of doing what is right.”

David Rae, head of asset allocation for New Zealand Superfund (NZ Super), also told the crowd about how the fund had recently brought ESG management “out of the back office to the front office.”

It’s a move he says, that had some of their investment professionals “kicking and screaming” about drafting their own policies but effectively “switched on their brains” about ESG and the costs and implications of getting it wrong.

It’s an approach that’s resulted in direct changes in major listed and unlisted companies NZ Super invests in, including changing supply chain issues in 16 technology companies, a complete change of board at another, and broke up “empire building” governance in a large listed infrastructure company.

Rae says their ‘active engagement’ on ESG won’t stop there, but is looking to build power in numbers through working together with other New Zealand funds on governance issues in particular.

“We recently got people in a room and said, ‘let’s raise corporate governance issues, and lets act as a group on these… we realise that tough talk in a locker room can quickly disintegrate on the field, so it’s important to have one company that’s leading that charge,” said Rae.