Case Study: Taming Volatility, Step-by-Step
How WCB Alberta restructured its portfolio in uncertain times.
BY John C.A. Hagen, CFA | July 11, 2017
Many defined benefit (DB) pension plans in Canada are focused on reducing volatility – especially given the lessons learned during the 2001 Tech Wreck and the 2008 Financial Crisis, when most pension funds experienced significant drawdowns. In this article, I offer an overview of the path to low volatility taken by WCB Alberta. While we were responding to the unique challenges and characteristics of our plan during this process, there are some lessons we learned that other plans considering de-risking might fund useful.
In our case, our need to significantly reduce volatility stems from the legislative imperative that the WCB-Alberta is to be fully-funded at all times. In that context, downside protection is critical. At the same time, we have a funding status of close to 130% which favors moderate risk.
As a result, our investment policy is based on a low volatility objective in addition to the usual actuarial return objective.
Our low volatility objective (that actual return standard deviation must be less than the policy benchmark standard deviation on both a one-year and four-year basis) has resulted in decisions about asset mix, manager platform structure and manager selection that have lowered volatility.
At the same time, we have used modeling to considerably transform our asset mix, identifying asset classes and an asset mix with low total fund volatility, better inflation pass-through, and satisfactory expected returns.
Inflation is Key
Our unique liabilities have considerable inflation sensitivity due to exposure to increasing medical costs for workers who have been injured. Inflation pass-through is important as a result.
Today, our asset mix has more real estate and now includes a significant exposure to infrastructure. Both asset classes demonstrate competitive returns, good inflation pass-through, and low volatility.
Similarly an increase in real return bonds also provides good inflation pass-through. Based on asset-liability studies done in 2008 and 2013, the higher risk private equity, private debt, and hedge fund strategies employed by many institutions were not ideal for us due to their downside risk potential.
Such asset mix considerations and the resulting changes to the asset mix (below) have been important key drivers of the WCB-Alberta’s volatility reduction. There are however several important supplemental factors.
Volatility Constrained Strategies
We have also made changes within each asset class to help reduce volatility.
We have a significant exposure to quantitative equities managed with modest risk objectives containing volatility. Today 30% of the WCB Alberta’s equities are managed using an enhanced passive strategy. The WCB Alberta also has significant exposure to low volatility U.S. equities focused on companies that have lower volatility than the index. This represents another 21% of the WCB-Alberta’s equities; so altogether, over 50% of the WCB-Alberta’s equities are managed using volatility constrained strategies.
We also use a core-plus approach for fixed income. Our core Canadian bond program is managed internally and is designed to take modest risk. The large internal core mandate is complemented by smaller satellite mandates for credit, commercial mortgages, infrastructure debt (floating rates), and global credit — in aggregate, these provide both good diversification and enhanced returns.
We’ve also increased our allocation to cash from 1% to 3% which lowers volatility.
The result: during 2016 our total fixed income (ex-cash) asset class standard deviation was 2.65 vs. the FTSE TMX Canada Universe Bond standard deviation of 3.41. Fixed Income (ex-cash) alpha was 1.62%, with a 1.76 Information Ratio, demonstrating excellent risk adjusted returns.
When it comes to inflation-sensitive investments, there are a myriad of infrastructure and real estate investment strategies available that reflect varying degrees of risk available.
We have tended to focus on strategies with good cash flow characteristics, modest greenfield or development risk, high inflation pass-through and modest leverage which together provide healthy cash returns without a high degree of volatility.
Within real estate, we are underweight the volatile office sector and overweight the less volatile industrial, residential and retail sectors which help reduce volatility.
For infrastructure, we favour large-scale global managers focused on core infrastructure, taking modest greenfield risk and utilizing modest leverage but also adding value as good operators.
To maintain liquidity, we also have a Canadian REIT mandate and a listed global infrastructure mandate – both have enhanced diversification and value added.
Passively hedging foreign currency exposure (USD hedged 25%, Non-US OECD currencies hedged 50%) has also helped reduce volatility.
Aside from core internal bonds, the remainder of our assets are managed externally, which means manager selection is critical. Selecting external investment managers that employ strategies consistent with our modest volatility philosophy has meant focusing primarily on prudent long-term investors with an investment process that is highly reliable over time.
Paying close attention to the correlation among other managers and mandates within the same sector also enhances the diversification effect which lowers total volatility. For the equity managers, we use the Barra One Risk System to compare incumbent and candidate managers in terms of both correlations and percentage contribution to active risk. While some managers still have elevated active risk, we use a manager platform for each sector that offsets risk characteristics and results in volatility reduction benefits at both the sector and the asset class level (below).
We monitor risk in several complementary ways. Standard deviation is used to assess the investment volatility objective. We measure contribution to portfolio allocated value at risk (VaR) to monitor risk at the individual mandate level. We measure the risk of not being fully funded using Barra One which tracks surplus at risk (SaR) — currently at 10.0%.
Barra One also measures total plan VaR and active risk. At December 31, 2016 total plan VaR was 7.1% at a 90% confidence level. This means that, based on the WCB-Alberta’s actual holdings, in one year out of 10 the total fund can be expected to underperform the expected return by more than 7.1%.
On the other hand, policy benchmark risk (the risk inherent in the policy asset mix) is 6.9%. The difference between total plan risk and policy benchmark risk reflects in part the active risk taken by the WCB-Alberta. This is driven by the difference between the actual asset mix and the policy mix as well as the extent to which investment manager portfolios are different from their individual benchmarks.
Taking 1.64% of Active Risk should, on average, allow us to achieve our 70-basis point value added target (chart below). The active risk of 164 basis points is apportioned among the WCB-Alberta’s various investment mandates in a risk budgeting exercise.
Barra One also allows various scenario stress tests to be performed, including market crashes, oil shocks, rising interest rates etc. These stress tests indicate that the existing holdings generally perform better than the passive benchmark in a rising rate environment and perform very well in most negative macroeconomic scenarios, including oil crises and market crashes.
Our fund would, however, underperform the benchmark when: (1) equities are up 10%; (2) real rates are down 100 bps and (3) BBB spreads are down 100 bps. Our low volatility approach works best when a defensive approach is required, for example when equities are down significantly, when credit spreads blow out, and during a rising rate environment. It will do less well when real interest rates decline sharply, credit spreads decline sharply, and equities rally strongly (i.e. a risk on environment).
Our returns have been favourable and value added has improved over the last 10 years. On a $10 billion dollar fund, 1.51% of value added for one year alone approximates $150 million dollars.
It is also interesting to look at the juxtaposition of total fund value added versus excess volatility (WCB-Alberta volatility – policy benchmark volatility). While volatility has declined (right-hand scale), value added has increased (left hand scale).
Over the last decade, the WCB-Alberta has evolved from a position where actual volatility was above our volatility target (in standard deviation terms) to become an institution where the actual volatility measure was comfortably below the WCB-Alberta’s volatility target.
Simultaneously we have delivered strong absolute and relative returns which have kept costs low for Alberta’s employers. To get there, we have made investment decisions that lower volatility and provide very solid investment performance.
Interestingly one can’t help but wonder whether at some level the same low volatility out-performance phenomena that exists within the equity asset class (resulting in the widespread adoption of low-vol equity strategies), may also have the potential to operate at the total fund level.
John C.A. Hagen is Head of Externally Managed Investments at WCB Alberta.