Dr. Damian Handzy admits he’s a skeptic. The chair and CEO of Investor Analytics, speaking yesterday at the Pension & Benefits Summit in Toronto, said skepticism is an overall approach that requires information to be well supported by evidence. But what has this got to do with pension risk?
With risk analytics, Handzy said, you need to know what it is, what it isn’t, how to interpret it and how to test it.
With this premise, he looked at both relative and absolute risk measures. “No pension fund is looking for relative returns,” said Handzy. “Everyone is looking for absolute returns.” The same can be said of risk.
Relative measures of risk (such as beta and tracking error) are good if you’re worried about matching the benchmark, Handzy explained, but not so good if you’re worried about losing money.
For example, beta is typically interpreted in the following way: if beta is greater than one, the fund is more volatile than the benchmark, and if it’s less than one, the fund is less volatile than the benchmark, he said. “But this is misleading. It can be true in certain circumstances. But if there’s no relationship between the index and the fund, it’s an inappropriate model for that fund,” he said. “It just doesn’t fit.”
Tracking error, a tool designed to help managers of index funds track their benchmarks, is another example. “This makes a lot of sense if your primary risk is associated with your investors having purchased a fund that promises to track a specific index, but this doesn’t make sense if you’re trying to limit your downside.”
Alternative managers, on the other hand, don’t use relative measures of risk. They use absolute measures (VaR, risk attribution, correlation, stresses), said Handzy, which are good if you’re worried about losing money.
The dynamic benchmark
Another issue is the benchmark itself. Through the second half of the last century, pension funds have had a traditional 60/40 mix, but in the last 10 to 15 years, funds have started to invest in alternatives, said Handzy. Hedge funds, private equity and real estate have very different volatility characteristics, he continued, and it’s not possible to capture that with a single benchmark.
Handzy suggests using a “basket” of benchmarks. A dynamic benchmark, in which the weights change regularly and the factors can change with time, is much better for alternatives, he explained, adding that this basket requires more oversight but provides a much better representation of the portfolio.
Reporting risk to the board
So if managers are using, or want to use, these absolute measures of risk, how do they report these absolute (advanced) measures to the pension board, whose members typically think about risk in terms of relative measures?
Keep the beta and tracking error measures at the front of your report but also introduce some absolute risk measures and begin to educate your board on these, Handzy says.
Next, add more of the advanced measures and then spend more time at your board meetings discussing these measures. Finally, at some point, put the advanced measures in front of the traditional measures in the report.