Investment Manager's Perspective | Benefits Canada.com

Opportunities and pitfalls.

The first part of the presentation focused on the observation that plan sponsors have a tendency to overestimate the importance of short-term performance of their investment managers, which can lead to sub optimal hiring and firing decisions. Typically, plan sponsors will evaluate their investment manager’s performance over a three- to five-year period, and this time period is not sufficient to properly evaluate a manager’s skill and ability to add value over complete market cycles.

This time period is being used on the premise that it historically represented a full business cycle. Data now indicate that business cycles are much longer in duration (in fact, they are closer to 10 years) and the contraction cycles are much shorter and the expansion cycles much longer than in the past. One main reason is that central banks have become more effective at managing monetary and fiscal policy to lead economies out of downturns much faster. As a consequence, GDP, inflation and production have all become less volatile in recent times, producing a longer business cycle.

Research has shown that investment returns may suffer when managers are terminated based on short-term performance. In one study of over 8,000 hiring decisions by more than 3,400 U.S. plan sponsors, returns were significantly less after the hiring of the new manager versus the subsequent returns of the manager just fired. Over the six-year period analyzed, returns were reduced, on average, by 2.8% per annum. In analyzing returns of Canadian investment managers, the five-year performance had no predictive value for the next five years, demonstrating that mean reversion does occur with investment managers.

Plan sponsors and consultants should look past short-term performance and evaluate investment managers on additional criteria. This would include personnel turnover, succession planning, a reversal of manager strategy or regulatory and/or compliance issues.

The second part of the presentation introduced a number of new products that are targeting the defined contribution (DC) marketplace in Canada. The first is known as an “Alpha-Transport” strategy, which, through the use of derivatives, attempts to increase the potential alpha from a bond portfolio. This strategy has some inherent risks that need to be evaluated in close detail before being offered to plan members. The same can be said for the use of hedge funds. There are over 10,000 hedge funds available that use a number of different complex strategies, and most of them charge high fees for their products. In addition, their lack of transparency may raise governance concerns for plan sponsors.

One product that has gained a lot of attention and acceptance in the DC marketplace in the U.S. is target date retirement funds. The 2006 Pension Protection Act, signed in the U.S., specifically names these funds as Qualified Default Investment Alternatives for DC plans. This legislative support has been a strong boon to these funds in the U.S., and it is expected that Canada will replicate the U.S. success.

Another type of product gaining attention in the DC market is long/short funds. These products short a certain percentage of the portfolio and use the proceeds to invest in additional long positions. The net result is a long exposure of 100%. For example, one popular type is known as 130/30 funds. In this case, 30% of the portfolio is invested in short positions, with the proceeds added to selected long positions to a total additional long position of 130%. Combined with the 30% short, the net portfolio position is 100% long. These funds may offer the single boost to potential alpha through the relaxation of the long-only constraint.

It is important to note that, with these funds, the portfolio can still achieve positive contribution from the short positions, even should these short positions rise in price. The important consideration is the spread difference between the long and short positions. As long as the long positions outperform the short positions, alpha will be increased.

There are a lot of new and exciting developments in the DC market and, with the expected growth in this area, investment managers need to continue to develop innovative products to meet the changing needs of both plan sponsors and plan members.

Alan Daxner is the executive vice-president of McLean Budden.

To view the presentation slides from the DC Summit, click here.

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