When Every Basis Point Counts
Coverage of the Risk Management Conference
BY Scot Blythe | February 7, 2018
It is one of the ironies – the act of derisking can actually increase risk, at least during the transition to a new portfolio. So says Travis Bagley, director of transition management at Russell Investments Implementation Services. “Your risk is that your current assets do not reflect the risk and return that you’re going to be using in the future,” he explains. “Plan sponsors invest a lot of work into what an asset allocation should be and what that policy portfolio should look like. The implementation of the transition to the new portfolio is, in many cases, just kind of an afterthought.”
For Newfoundland and Labrador’s Public Service Pension Plan, there was a lot more work than just transitioning to a new portfolio – and this illustrates some of the challenges other funds might face. Here, derisking was part of a comprehensive reform of the way the pension plan invested and was governed.
Prior to 2014, the trustee for Newfoundland and Labrador’s pension plan was the minister of finance, advised by a layperson investment committee. Natasha Trainor, now the chief investment officer of Provident 10, was the sole member of the investment team.
The plan was only 65% funded. “Consequently, we had a very aggressive asset mix, with an unrealistic goal of trying to invest our way out of this problem,” she says. To fix the problem, a new pension and investment management corporation was created, Provident 10, with a new board representing all the stakeholders and an investment committee with more expertise.
“A major part of the reform deal was that the asset mix was going to be derisked away from the large equity exposure we had in the past to reduce the volatility plan members had experienced in recent years,” Trainor notes. That meant moving from an 80/20 equity/bond portfolio to a 60/40 balanced portfolio, with a much more diversified mix of asset classes.
Getting there, however, took some time, and a lot of effort. “We had a brand new board of directors that was tasked not only with implementing the new investment strategy but also with setting up the brand new pension corporation,” she recalls. “I encouraged them to remember that there was risk in delaying the implementation of the new policies that were part of the reform deal.”
The alternative to delay was a derivatives overlay, which allowed the plan to get exposure to the new policy mix before making the full physical transition – a process that took almost a full year.
The implementation approach was key. “When you have these exposures in derivatives markets combined with the underlying physical markets, they have to be traded in conjunction,” notes Bagley. “They have to be managed very carefully so that you’re not underexposed to the market and you don’t have leverage in the plan. We were very keen on making sure that changes in the synthetic portfolio matched up with changes in the physical portfolio in real time.”
“At the time, I was still the only person working on the investments and it was a daunting task to think of the amount of work required to be done and the amount of time it would take,” Trainor says. “So this is why we chose to use an overlay strategy to synthetically replicate our new asset mix. It was a way to change the risk pro le of our asset mix in a timely manner.”
In the end, the synthetic portfolio, as a whole, created a performance advantage of 73 basis points relative to the legacy portfolio, and tracking error relative to the new policy portfolio was reduced by 74%.
“One of the great benefits of using overlay programs for these asset shifts is that it buys you time,” concludes Bagley. And sometimes, a little bit of outperformance.