Crank Up Your Active Risk

There's only one way to earn more than 5% right now...

March 29, 2012

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volume controlIf a balanced portfolio is going to earn 5% nominal from market returns (50% equity at 7.5% & 50% bonds at 2.5%) over the next decade and a scheme requires more than 5% to make things work (i.e., to meet the required return and regain full funding if underfunded), then there are a few options for trying to raise returns above 5%.

Adding other Beta might be the first step and this is already employed in most plans. The average allocation of institutional funds in Canada is roughly 33% fixed income, 42% public equities and 25% other, as reported by Canadian pension plan through PIAC.

The other asset mix category is primarily real estate, infrastructure and private equity.  Taking out active returns, and after the high fees associated with these asset classes, I would argue that reasonable return expectations for these asset classes are still in the single digits.  Cap rates on Canadian real estate are in the 5% to 7% range, infrastructure and private equity managers are still promising returns in the low teens but that seems to be somewhat biased to the upside and includes generous active management aspirations.

Reasonable market return expectations are therefore 2% to 3% for bonds, 7% to 8% for equities, 5% to 7% for real estate, 7% to 10% for infrastructure and similar for private equity.  With an asset mix consistent with the average Canadian pension fund, the total return expectation is 5.9%, which rounds up to 6% nominal, but my gut tells me this is somewhat optimistic.

If 6% nominal is enough then you are in a pretty envious position.  I think most institutional funds need much more than 6%, particularly if in an underfunded situation.  If 6% is the best you can get from the Beta, then the last piece of the puzzle is active management. Active management can’t by definition solve the problem for all plans, but perhaps it can for some. If you are deploying active management, you must first ask the hard questions. Can you be successful? Do you, your internal staff, and/or consultant advisors have a competitive advantage in portfolio management and/or manager selection?

If the answer to both of these questions is yes, I would suggest that you engage in a fully active approach. By fully active I mean a strategy with enough active management to meet your policy value added target and make a difference to plan funding.

Many plans have total fund active return targets of 100 basis points (bps) to 150 bps in their investment policies. My hunch is that most of those same plans aren’t taking enough active risk to be able to meet those targets. You might look at the value added targets for each mandate or asset class, take a weighted average and come up with something in the 100 bps to 150 bps range but the problem is that no matter how good you are, all your managers and mandates will not be successful and actually meet the targets.  Further, the active returns are in most cases uncorrelated with each other, which is a good thing. However the active returns diversify and the total fund active risk is much lower than the simple weighted average.

For exameple, WCB-Alberta deploys active management in nearly 100% of the fund, the weighted average active risk, as measured by projected tracking error (1 standard deviation of active risk) is currently 342 bps.  However the actual total fund projected tracking error — when properly calculated and when diversification of active risk is considered — is only 120 bps. Making the bold assumption that we are better than average I can assume an information ratio (active return/active risk) of 0.5 (approx. top 1/3 of funds) and I can therefore expect value added of 60 bps (Value added = information ratio/tracking error).

With the same 0.5 information ratio, and an active return target of 125 bps, you need 250 bps of projected tracking error, double the amount taken by my fund, which is nearly 100% actively managed.

Are you taking enough active risk?  The answer is probably not, so if you need active management to help bridge the gap, and you think you can win the game, and you really want 100 bps or 125 bps of active return, you better start looking for ways to crank up the active risk.

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