Field Notes Managing Risk in a Post-September 11th World
IN PRINT ARCHIVE CIR Winter 2001
|Managing Risk in a Post-September 11 World|
|by Keith Ambachtsheer|
RISK IS BACK
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?
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?
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
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. *
|Keith Ambachtsheer is President of KPA Advisory Services, Partner in Cost Effectiveness Measurement (CEM), President of The Association of Canadian Pension Management (ACPM), and a member of the Canadian Investment Review Advisory Board.|