Pension Funds
The risk assessment processes for pension funds are focused on the future. Past risk levels of the portfolio are of little or no consequence. Risk assessment should come from formal risk systems that combine forward-looking assessments of market conditions and the best available information on specific assets that will comprise the portfolio in the future. In almost all cases, the current portfolio is the best estimator of the composition of the portfolio for the foreseeable future.
Pension funds often allocate a portion of their assets to some very volatile investments such as leveraged hedge funds that are capable of going bankrupt in an extreme market event. For these assets, risk assessment is less an issue of investment policy and more an issue of monitoring the solvency of the fund. Few, if any, pension fund investment statements explicitly address the forward time horizon of risk assessment.
Many investment policy statements for pension funds simply overlook the risk of illiquid alternative investments such as private equity, venture capital, and real estate, as simply unknowable, feeling it is appropriate to ignore them for risk assessment purposes. If a pension fund owns an illiquid asset as an investment, the true economic value of that asset is changing on a daily basis even if it cannot be observed. While there is a wide range of methods available to assess the risk of alternative investments, the guiding principal must be that risk assessments for pension funds should incorporate 100% of the fund assets including illiquid alternatives.
Many pension investment policy statements focus a great deal of attention on the potential for active managers to underperform their benchmarks. Unfortunately, fund sponsors incorrectly use tracking error as the measure of active risk. The central paradox of active management is that every active manager and investor who hires an active manager must believe that the mean of their benchmark relative returns will be positive. Unfortunately, it is mathematically true that roughly half of active managers must produce below average returns. Unless one assumes that a fund has a 100% success rate in hiring superior managers, assessing the risk of active managers requires a broader measure that incorporates both the dispersion of returns around their mean, and the potential for the mean to be negative over the future.
The professionals at Gateway Partners can help guide clients through issues such as these. Quantifying risk is a necessary discipline, and by working with us, pension funds can get a better grasp of their risk profiles, providing an extra layer of oversight to protect their most important asset – the people they serve.
