1. abcd Active Management or the Equity Risk Premium: Place Your Bets
Investment Risk Working Party
Finance and investment Conference
22-24 June 2003

2. A Perfect Storm?
Market-based valuations
Weak equity markets
Greater trustee accountability
Media highlighting pension disasters

3. Increased focus on investment risk
‘The focus of consulting actuaries used to be on how to maximise the long-run investment returns of pension funds and reduce costs to the sponsoring companies. Now the emphasis has shifted to the measurement and management of short-term solvency problems and the protection of beneficiaries.’
Barry Riley, Financial News 5th May
‘The attention devoted to asset allocation decisions should fully reflect the contribution they can make to achieving the fund’s investment objective’.
‘Where they believe active management to have the potential to achieve higher returns, funds should set both targets and risk controls which reflect this, allowing sufficient freedom for genuinely active management to occur’.
Recommendations of Myners report, 2000

4. Overview
Merits of strategic and active risk
Rationale for current split
Tailoring the split of risk
“Unconstrained” mandates

5. Background definitions
Investment Risk
Minimum Risk Position
Strategic/Market Risk
Active Risk

6. Market risk versus active risk
Positive equity risk premium
implies risk likely to be rewarded
over the long-term
Zero-sum game but…
… pension funds may have
advantage in accessing “alpha”
… risk-return trade-off superior if skilful managers can be identified
Costs of up to about 10 basis points (based on passive investing)
Cost between 20 and 200 basis points depending on size and nature of fund (i.e. higher for long-short)

7. Risk return trade-off: Market risk only
EXPECTED RETURN
STRATEGY TOOL KIT
change market risk
pursue active management

8. Risk return trade-off: Typical pension fund
Currently over 90% of expected total risk is spent capturing the market risk premium while less than 10% is allocated to capturing active returns
EXPECTED RETURN

9. Why does market risk swamp active risk?
Lower return expectations for active risk
Diversification of active risk
Unintentionally high market risk
Regret aversion/herding
Myopic loss aversion resulting in index-hugging

10. Risk return trade-off: Optimal Split
An optimal implementation of this strategy will allocate your total risk budget based on your expected risk-return (IR) of selected active investment strategies and your expected risk-return (Sharpe ratio) of asset classes from your strategic asset allocation analysis
EXPECTED RETURN

11. Diversification Benefits
Even small levels of alpha highly valued
A typical fund should increase active risk if believe net IR > 0.06
Even greater benefits if multiple skilled managers can be found

12. Tailoring the split of risk
Passive investing to gain pure market exposure
Market-neutral to gain pure active exposure:
Portable alpha:
Based on proven long-only strategy
Long-short
Can efficiently gear alpha
Investor comfort?

13. If the trustees believes in active management:
Place Your Bets
If the trustees believes in active management:
Should increase active risk as proportion of total
… but regret risk high
… limited ability to gear alpha without long-short
Strong conviction needed to break away from the herd

14. Unconstrained mandates
Focus on long-term
Less turnover
Index weightings ignored
Genuine active management

15. Unconstrained mandates - grey areas
Market-neutral / Equity-based / Manager discretion?
Measure of success and risk?
Performance fees?
Activism?
Can trustees withstand significant short-term poor performance?
Another working party? To be continued…..