Field Notes Managing Risk in a Post-September 11th World

RISK IS BACK
With the benefit of hindsight we can now say that for institutional investors, the decades of the 1980s and the 1990s were about managing returns. The game was all about what kinds of risky securities to be in, and when. North American value shares, any kind of Japanese share, and long bonds were the ticket in the 1980s. North American growth shares and zero Japanese exposure were the way to go in the 1990s. The 1990s were also a great decade for private equities, with the year 2000 a good exit point if you could manage it.

By the end of this 20-year bonanza, a double-digit return mindset had developed. 'Poor' multi-year fund returns during this period were counted in the low 'teens', 'good' returns were in the high 'teens'. Trustees of pension and endowment funds were taught a mantra by their professional advisors that over the long term, equity investing was low risk, and any other kind of investment policy was higher risk. In other words, the double-digit returns being recorded were pretty certain to continue as long as investors were willing to be patient.

This fantasy world ended with the market peaks in March 2000, although few people realized it at the time. It ended because by then, there was no one left to pass the game's 'Old Maids' (e.g., the Ciscos and Nortels) to at higher prices. Even as of October 2001, at much lower prices, the simple arithmetic of stock returns continued to tell a sombre tale. A 2 per cent dividend yield plus a 2 per cent real dividend growth rate on the TSE300 add up to only a 4 per cent real return, not much better than the prevailing 3.7 per cent Government of Canada real return bond yield. In other words, even today there is precious little 'risk premium' embedded in stock prices.

Meanwhile, September 11 has happened. Hypothetical risks have become palpable risks. Hypothetical risk premiums based on a rosy past are now in the process of being converted to tangible risk premium calculations based on realistic assessments of a highly uncertain future. We believe that for stocks, that will eventually mean higher current dividends and dividend yields. Shareholders will increasingly want to see the money, rather than permitting managements to fritter it away on funding unproductive acquisitions, and executive stock option programs. How much of that extra money (i.e., higher dividend yields) will come through higher payouts, and how much through lower share prices remains to be seen.

WHOSE RISKS WILL BE MANAGED?
So we are all risk managers once again. However, before we let the experts in the nitty-gritty of risk management techniques take over, we would do well to ask the big questions about risk management first. For example, whose risks are we going to manage? Those of the principals or those of the agents? And even if we get the answer to this first question right (i.e., 'the risks of the principals'), do we know who the principals really are?

Take a defined benefit pension plan, for example. The principals are the plan members and plan sponsors (usually either shareholders or taxpayers). The agents are the plan administrator and the various internal and external advisors and investment managers employed by the plan. Make no mistake, the principals and agents in this situation face very different risks. The principals' major risks are that of pension payment default and/or an unanticipated increase in plan contributions. The agents' major risks are falling compensation levels and/or possible termination of employment. These are very different types of risks requiring very different management strategies.

A tangible example will help make this point clear. We were recently contacted by a major public sector investment agency with a number of captive 'clients'. The agency wanted to know what the 1990s 'information ratio' experience of Canadian pension funds was. Would that be at the total fund vs. total plan liabilities level, we asked? No, they were not interested in that. They were only interested at implementation return vs. implementation risk level. Why, we asked? The totally rational response was that the agency got paid for its implementation prowess, and not for how well their clients' total balance sheet performed! We asked who managed their clients' total balance sheet risk. Apparently that was somebody else's problem. It was not clear who that somebody was.

WOULD THE REAL PRINCIPALS STAND UP?
Is a total balance sheet risk management focus the final answer then? Not necessarily. For example, as the principals in DB pension plans, do plan members and plan sponsors (i.e., ultimately shareholders or taxpayers) really face the same risks? Usually not. Often, the risk structures in these plans are asymmetric, with the sponsors underwriting most of the asset shortfall risk, and the plan members benefiting from most of the asset surplus windfalls. Fiduciaries such as pension fund trustees have a legal obligation to be 'even-handed' in their risk management decisions. Is that possible in cases where the 'pension deal' itself is not even-handed?

Once again, a tangible example will help make this point clear. Most corporate DB plan sponsors are still 'stuck' with pension contracts where they are under a clear legal obligation to make up any unfunded liabilities in short order. You would think that this requirement would automatically entitle them to withdraw any surplus assets in short order as well. Not so! Pension law states that this can only be done with plan member agreement. Effectively this means that while corporate sponsors must make up 100 per cent of asset shortfalls, they must share asset surpluses with plan participants. In contrast, many public sector plans are moving to the 50-50 reward-risk sharing formula pioneered by Ontario's teachers and government. Mind you, thus far we have only seen the formula operate on the surplus- sharing side. It remains to be seen how it operates on the deficit-sharing side.

GOOD RISK MANAGEMENT MEANS GOOD GOVERNANCE
In conclusion, we believe that institutional investing in Canada has arrived at a major watershed. The gravy days of return management are over. They have been replaced by a much more demanding age of risk management. However, before we turn our professional lives over to the rocket scientists with their arsenals of modern risk management tools, we would do well to pause. Let us be clear about whose risks need to be managed. It is the principals' risks that should be primary in our considerations, and not those of the agents. However, as we noted, that may be a more challenging proposition than it at first seems.

This leads to one final point. Good investment fund risk management is entirely dependent on good investment fund governance. There is no more important governance responsibility than to understand who the principals in a specific investment fund context are, and what kind of risk budget, and minimum required risk-reward trade-off that context implies. It remains to be seen whether the governing fiduciaries of Canada's investment funds are up to their primary task. *