Leverage: The Good, The Bad, The Benign

Coverage from the 2010 Risk Management Conference.

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1084848_revolverLeverage can be categorized as the good, the bad and the benign, said Calvin Jordan, CEO of the $3-billion NSAHO Pension Plan, speaking at the Risk Management Conference in Muskoka, Ont.

The NSAHO has implemented some investing ideas that have been around for a while, Jordan said, adding that this theory of risk budgeting and liability driven investing can actually be put into practice—regardless of limited internal resources.

“DB pension plans,” he emphasized, “can be saved by those who are committed to saving them.”

The Good

Beginning with the best of the trio, “good” leverage reduces uncompensated policy risk. This is done through hedging interest and inflation rate risk. Jordan explained that their strategy uses bond forwards and repos to leverage additional bond exposure beyond what would be possible if they only used physical assets. They have 65% fixed income exposure while only using 25% of their physical assets.

Jordan points out “Sixty-five percent may not be the perfect allocation, but I don’t know what the perfect allocation is”. He continued “Don’t miss good looking for perfect. If we had hedged more than 65%, we may have found ourselves overhedged because of the sensitivities that exist in other asset classes.”

Jordan argues that the 40% unfunded part of his bond strategy not only reduces risk, but may also increase expected returns. The expected return enhancement results if the yield curve in the future is upward sloping on average. With an upward sloping yield curve the expected return from the bonds is higher than the expected cost of financing inherent in the derivatives.

But Jordan stressed that any increase in expected returns is a bonus. The point of the exercise, is just to make the assets better match the liabilities from a risk budgeting perspective.

One more bonus of the strategy is that it may indirectly provide solvency relief, said Jordan. If your actuary agrees that expected returns used in your going concern valuation are increased, your current service cost will decrease, leaving more of your contributions left over for solvency special payments.

The Bad

The “bad” part of leverage that Jordan highlighted was the credit spread charged by mortgage lenders on real estate assets. To minimize credit spreads the NSAHO Pension Plan tries to position leverage in the fund where it is cheapest. They keep mortgage debt as low as possible, and in its place access leverage implicitly with synthetic exposures in other asset classes.

Jordan says he’s heard a few arguments against NSAHO’s approach:

• leverage within the real estate portfolio is necessary to get reasonable diversification; and

• a reasonable amount of leverage can help increase returns.

He explained that these arguments don’t hold water, as his strategy doesn’t reduce total fund leverage, but only shifts it to where the credit spreads are cheapest. The gross exposure to real estate beta doesn’t need to be reduced.

The Benign

That leaves the “benign,” increasing expected compensation from the active risk budget (portable alpha).

Jordan compared the traditional approach versus the portable alpha approach using a large cap US equity example. Traditionally, you invest cash in U.S. equities and get the U.S. market index return plus the value added from active management, he said.

With portable alpha, the exposure to U.S. equities comes from an unfunded derivative instrument. The NSAHO Pension Plan uses the cash that is left unused to invest in hedge funds, with the hedge funds selected to have reasonably low equity beta. The alpha is the hedge fund return less the financing cost that is inherent in the derivatives. Jordan argued that even if you assume a fairly low hedge fund return, with today’s low financing costs you may improve your expected compensation from your active risk budget.

Of course the hedge funds could provide negative returns, but Jordan compared this risk to the chance that an active manager would provide negative alpha. It’s a risk but Jordan argued that the potential impact on the total fund is minimal relative to a fund’s policy or beta risks. And if you wish you can limit the risks related to portable alpha by reducing the amount of your portable alpha exposure.

Taking all of their strategies together, Jordan indicated that they estimated that they had increased their expected real returns by about a third, and reduced their expected funded position risk by about a quarter. This is compared to a typical 60% equities, 40% debt asset mix.

Risks of these leverage strategies can include liquidity risk, counterparty risk, headline risk, career risk and key employee risk. Jordan agreed that such risks need to be managed but remained unfazed. “The 60%/40% alternative to these strategies also has its risks” he concluded.

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