Pension funds and money managers are still feeling the effects of the credit crunch. Will the new focus on risk management survive the latest storm?

Call it a complete risk rethink. That’s what many say happened following the perfect storm of 2000, when dire equity market returns, combined with historically low interest rates, gave most defined benefit(DB) pension funds a major shock. In the years since, risk management has begun to replace asset management as plan sponsors seek to match assets and liabilities in an effort to avoid similar problems. But as storm clouds gather again in the wake of the collapsing asset-backed commercial paper(ABCP)market in Canada, it remains to be seen whether the new risk management focus will immunize DB pension funds from the latest crisis. In fact, there are some who think the ABCP fiasco could cast alternative managers in a negative light and cause plan sponsors to shun some of the strategies that are central to risk management approaches, such as liability-driven investing(LDI).

In this year’s Top 40 Money Managers Report, we asked managers to talk to us about how they see the credit crunch affecting their industry and their clients—and whether or not the burgeoning market for risk management tools and strategies can provide the necessary support plan sponsors need to stay afloat in rough waters. As the crunch spreads, the Canadian dollar peaks and markets show their shaky side, this year’s Top 40 will no doubt have their work cut out for them.

The Numbers

Let’s start by looking at what the numbers say. There were no big shakeups in the top five this year, and the Caisse de dépôt et placement du Québec, Barclays Global Investors Canada Limited, TD Asset Management Group, Phillips, Hager & North Investment Management Ltd., and State Street Global Advisors Ltd. all held on to the same spots. In fact, most of the managers on the list maintained similar rankings to last year, and there were no precipitous drops or huge gains.

Among the top 10 fastest growing managers, in dollar terms, Caisse de dépôt et placement du Québec led the pack, growing its assets by $22.6 billion. Big global players took the other top spots—AllianceBernstein grew its assets by $8.5 billion and Barclays Global Investors Canada and State Street were next on the list, neck in neck at gains of $4.8 billion each.

Part of the growth story for some firms has come from a focus on products geared to risk management. Gregory Chrispin, president and managing director at State Street Global Advisors in Canada, says that clients, big and small, are preoccupied with risk management, and that is driving much of the new business his firm is seeing. This means extension strategies and other tools that allow plan sponsors to make their assets work more efficiently for them. “It touches on risk management and, to a large extent, liabilitydriven investing,” he explains. “LDI is another way to put the focus on risk as people realize that the investment environment is much different today.

Tarred and Feathered?

Given the challenges faced by plan sponsors in today’s environment, many say that risk management will continue to be in the spotlight—particularly as the effects of the credit crunch continue to ripple through Canada where the market for ABCP effectively seized up in August due to worries about exposure to the U.S. subprime mortgage market. While it’s not certain just how broadly the ABCP problems will spread in Canada, there are some in the industry who think that it could taint other alternative investments in the eyes of plan sponsors. The problem is that many alternative strategies are central to the risk management tools that pension funds need to weather the current volatility.

Phillips, Hager & North ranks among the fastest growing firms and has seen its total assets grow to $67.5 billion. Firm president John Montalbano, in Vancouver, is one of the people worried about the future of derivatives in the wake of the credit crunch. “The unfortunate fallout of this is that legitimate investment vehicles that facilitate liquidity or are productive risk management tools, such as the derivatives market, will be tarred and feathered alongside the tainted third-party asset-backed market,” he warns. “The derivatives market can play a meaningful role for pension plans, but our fear is that the recent events will turn back the clock to where we were even five years ago, when plan trustees would not even welcome a discussion on the topic.” This means that money managers will still have an uphill battle ahead of them when it comes to educating their clients, he notes.

Bill Chinery, managing director at Barclays Global Investors in San Francisco, agrees that many investors fell into a false sense of security in the credit market because the risk wasn’t priced correctly. “Spreads that were so narrow suddenly widened out and went way past normal, all in a day or two. It caught everyone off guard,” he explains. Other Top 40 managers who now see increasing pressure from plan sponsor clients on the horizon echo that sentiment. Roger Beauchemin, president and chief operating officer with McLean Budden(eighth on this year’s Top 40 list)in Toronto, says that while the full impact of the crisis still hasn’t been assessed, the market reaction will likely prompt more plan sponsors to take a closer look at risk and to push for clarity and transparency. “I imagine there will be more regulatory pressure on ABCPs and alternative investments,” he notes. “Recent events will certainly make opaque financial engineering products a lot less appealing. In fact, the crisis can be viewed as a reflection of too many investors being focused on the short term and hungry for incremental yield, with a resulting reduction and, in certain cases, outright elimination of risk premia.”

According to JJ Woolverton, managing director and chief operating officer with Guardian Capital in Vancouver(27th on the Top 40 list), the credit crunch adds up to a big credibility challenge for money managers, who will have to demonstrate a lot more integrity when it comes to sizing up investment vehicles for their clients. “There will have to be more transparency,” he says. “There will be more pension funds asking for external audits of the policies and procedures of the money management firms. The good news—it is probably the excuse needed for the regulators to go after the hedge funds.”

At the same time, however, hedge funds have moved more and more into the mainstream in recent years and have become a staple among institutions. Moreover, their role as a mainstay of many institutional portfolios has accelerated in recent years with the introduction of new strategies that mix traditional investment approaches with alternatives. One big example of this meeting of alternative and mainstream is the advent of short-extension strategies, such as 130/30, which mix long-only equity with short selling. They aim to take the hedge fund industry to a whole new level, as shorting stocks becomes a new way for traditional long-only managers to add value. While 130/30 has attracted some skeptics in the industry, Chinery says the approach is here to stay—and that it’s poised to expand in the future. “Traditional long-only managers have got to start looking at how to add value by shorting stocks and not just buying stocks, and not following the ones they don’t like,” he notes. Quite simply, he says, “removing the long-only constraint makes investing more efficient.”

“Opaque” Excuse Doesn’t Cut It

But for such strategies to really take hold, many believe that managers are going to have to get much better at explaining what they do to their clients. Len Racioppo, president of Jarislowsky, Fraser Limited(sixth on the Top 40 list) in Toronto, sees clients turning up the heat on their managers and demanding answers that go beyond the tired “opaque” explanation. “The manager’s knowledge and understanding of the investments themselves will also come under scrutiny,” he says. “To say that some investment products are opaque or that significant assumptions were made or even that a rating agency was relied upon is not good enough.” Racioppo notes that money managers are looked to as the experts—and that is what clients pay them for. “In the end, there will indeed be changes—manager changes and policy changes,” he notes, adding that risk tolerances will also be adjusted and new parameters set.

As the industry works to assess exactly how it got into the credit crunch mess, there are other developments afoot, including a fast-paced move out of Canada and into global assets in a post-Foreign Property Rule landscape. Naturally, the strength of the Canadian dollar has helped speed them across the border. As the loonie floats around the parity level with its U.S. counterpart, it doesn’t look as if Canadian investors are going to be coming home any time soon. “The bigger impact of the rising dollar, I believe, is that it will lead to an acceleration of assets moving out of Canada and into foreign stocks and bonds,” says Montalbano. “With the Canadian dollar at par, it is psychologically easier to make the shift into foreign assets. There will be a significant number of trustees who take the view that a Canadian dollar at par is not sustainable, thus making the move into foreign assets all the more attractive from a timing perspective.”

At the same time, the Canadian market is getting thinner than ever. With income trusts off the table and more big Canadian companies being stripped out of equity markets through foreign takeovers and big private equity deals, the task of diversification in Canada becomes harder than ever. And as Canadian plan sponsors eye foreign equities and fixed income, they’re also looking at asset classes such as private equity, infrastructure and alternatives to help manage risks and get the necessary diversification. Robert Brunelle’s Montreal-based firm, Hexavest, isn’t in this year’s Top 40, but he has been part of the fastest growing list in the past. With a specialty in global equity, Brunelle actually sees the Canadian equity market becoming part of a continental focus. “I wouldn’t be surprised if we see a trend to North American equity mandates,” he says.

Breaking Up the Herd

Many in the pension industry in Canada have complained about the so-called “herd mentality” that sometimes drives plan sponsors toward investment approaches and strategies that aren’t always the most effective for them. However, the renewed focus on asset-liability matching and risk is, for some, a sign that the herd is finally breaking up, as plan sponsors look more closely at their individual liabilities and risks. Chrispin says there will be a lot more requests for customization in the future—“it’s no longer a one size fits all,” he explains. As plan sponsors move away from a traditional focus on asset allocation, he says they’ll be looking inwardly at the needs of their plans. “Risk management, liability-driven investing, tactical asset allocation—plan sponsors need to manage their assets in conjunction with their liabilities,” Chrispin explains.

Montalbano also sees LDI as a major part of the future, and that will create an education challenge for many plan sponsors and their boards. “Plan customization continues to gain momentum,” he explains. “But the benefits of such strategies are not entirely obvious to a trustee not schooled in finance.” He notes that as plan sponsors move away from the old “horse race” approach focusing on peer group-relative performance, education will be key—“the landscape of opportunities and risks changes dramatically, as does the governance structure needed to support it.”

Michelle Savoy, president of Capital Guardian in Toronto (26th on the Top 40 list) agrees that it’s time for money managers in particular to step away from the herd. “Managers need to add value,” she says. “We need to concentrate and perfect what we can do and not what is in vogue. Outsized gains are not realized by following the crowd. Success will come more from being good partners rather than just beating an asset class benchmark.”

As plan sponsors work to understand the new box of risk management tools in front of them, there are some in the industry who believe that they’ll start looking for even simpler ways to handle the pension promise in the future. In particular, sponsors of defined contribution(DC)plans, long saddled with the task of trying to educate and engage their employees about the importance of retirement planning, are starting to gravitate to one-stop options for their plan members. Life path and so-called “target date” products that can be customized to individual needs can give employees a better chance of saving enough money to retire without the burden of complex decision-making. Says Chinery: “You’re not going to give an employee a million choices. If you go back to the late ’80s and ’90s, I used to think the answer was to educate employees. That’s never going to happen. You can never educate enough people to do that. You’ve got to give them more balanced-type products and, when they retire, more annuity-type products.”

The same could also be said for DB plans: as plan sponsors and trustees seek to understand and embrace an increasingly complex world of risk management and asset-liability matching, they might one day decide to outsource the whole pension fund to someone else. Complete outsourcing is going to be part of the future, believes Chinery. “Right now, the treasurer runs the pension plan. And it’s the same argument as DC—it’s not their area of expertise.” Chinery says an industry could grow that can take over the whole pension plan and manage it for the sponsor. Think that’s impossible? Then consider the fate of the now-lowly payroll function, says Chinery. “If you go back 30 years ago, hardly anyone outsourced their own payroll,” he says. “Now nobody does their own payroll.”

Does all this mean that terms such as “opaque,” “herd” and “asset allocation” will be stripped out of the Canadian pension industry vocabulary for good? Probably not. But what this year’s Top 40 report does reveal is a critical shift taking place, as plan sponsors and their money managers seek to regain their balance in an increasingly challenging investment environment. As alternatives meet mainstream approaches and as cracks appear in some of those alternatives, it remains to be seen whether or not some of the approaches that have become more widespread in recent years will experience a setback due to wary clients. At the same time, those same plan sponsors stand poised to take advantage of a new global palette of choices as they start to step away from Canadian markets.

On the surface, some say the future may look a lot like the past, with an insurance-like approach to plan management and total outsourcing in the cards. However, there will be a host of sophisticated products and strategies underpinning the whole structure. And understanding what lies on the underside will still be critical for both plan sponsors and their money managers.

Caroline Cakebread is the editor of Canadian Investment Review. caroline.cakebread@rogers.com

For a PDF version of this article(which contains all the charts, including the Top 40 Money Managers), click here.

© Copyright 2007 Rogers Publishing Ltd. This article first appeared in the November 2007 edition of BENEFITS CANADA magazine.

 

Copyright © 2019 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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