How Do You Handle Equity Risk?

Coverage of the 2011 Risk Management Conference.

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rodeo bronco horseRisk is strongly influenced by the situation of the individual.  A case in point might be the difference between opening your car door and stepping out in your driveway at home versus the same activity on the shoulder of a busy highway or on a steep grade.  The one situation we perform thousands of times without thinking – the other we do with thought and precaution for our safety.

The simple everyday method of assessing risk in a situational manner seems to have been widely underutilized in addressing equity risk for pension plans.  Plan sponsors have come to realize the funding risk tied to interest rate declines and many have abandoned the long held tradition of managing market risk in favour of managing funding risk.  In simple terms, many sponsors have begun to frame risk based on their situation as opposed to a generic risk in the market.

Much of the change in focus has centered on bond portfolios and interest rate risk causing a major change in the landscape of how bond assets are managed for pension plans that is largely divorced from the management of market based risk measures as a useful reference.

When one adopts this situational viewpoint to the equity portion of the assets, we see that more work in the equity space is needed.  Sponsors are very concerned with the volatility of equity exposure and the associated impact of this volatility on funding requirements.  When viewed from this perspective, an old saying comes to mind “sometimes they way we look at the problem is the problem.”  Quite simply, the current school of thought that manages and measures equity risk versus market portfolios has failed to adequately address this risk faced by pension plans.

In examining the hundred-year history of the Dow chart below, two things become apparent.  The long-term return is attractive for pension plans, but the pattern of return, in particular four decade long periods where the market offered little or no return, poses difficulties for those trying to manage a pension plan.  Consequently, relative market-based risk measures such as volatility, alpha, beta and tracking error may not adequately be addressing the equity risks to managing a pension plan.  This may be why those sitting on pension committees get an unsettled feeling when a manager produces positive alpha with market-like beta and volatility and tracking error within tolerances, but loses 19% when the market is down 20%.  The manager has done their job and yet likely created a problem for the plan.  One wonders if the plan hasn’t given the manager the wrong job.  Ask yourself the question, outside the investment world, if your employees achieved a goal or metric set out for their success ten times out of ten, but four times out of ten the company was put into severe financial distress, would you consider changing this metric? Download the full paper here.

Wayne Wilson HBA, MBA, is Vice-President, Lincluden Investment Management.

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