What’s Your Factor Exposure?

story_images_dice-rolling-riskA panel discussion—with Terri Troy, CEO, HRM Pension Plan; Eric Fechter, director, treasury, Teck Resources Ltd.; and Yasir Mallick, senior portfolio manager, total portfolio and risk, Ontario Power Generation—looked at risk factors and how pension funds are using them.

Here are a few highlights of the discussion.

Q: What are factors, and why are you using them in your plans?

Traditionally, portfolios were viewed as a combination of alpha and beta. But today, investors are looking at factors persistent in alpha that you can replicate on a more cost-effective basis than pursuing alpha, Troy explained. “At a high level, these include equities, interest rates, credit and inflation. And underneath all those different levels are secondary factors,” such as value, momentum and growth for equities, or yield curve and duration for rates, she added.

The HRM Pension Committee’s objective is to minimize contribution increases and/or benefit reductions on annual basis since actuarial valuations are required to filed on an annual basis.  “We finally obtained “permanent exemption” from funding on a solvency basis…now, our objective is going-concern, so it’s more of an absolute-return focus,” she said.

As a corporate, Teck’s plan is always subject to solvency funding. And, although the plan is currently fully funded, “we’re always looking at things like interest rate sensitivities for our liabilities,” said Fechter. He explained that the plan aims to have consistent contribution rates and uses factors such as rate sensitivity and duration. Since the company is itself a commodity producer, it also uses factors to avoid “doubling down” on commodities, he added.

OPG has a large investment program but fewer resources, so it’s essentially a time management exercise, Mallick explained. “We looked at primary factors, because anything below the primary factors, we thought the investment team was really the one responsible to look at style and sector rotation and all those other things.” In terms of primary factors, he said, the equity factor dominated the portfolio, so the plan was looking for ways to bring down the equity factor without compromising returns or significantly raising contribution rates. This led to a new focus on stress testing and scenario analysis.

Q: How do you use scenario analysis and stress testing? Are there any challenges with it?

“We wanted something that was built into our risk infrastructure, that was automated, that was seamless, that produced risk dashboards daily…we include our assets, our liabilities and our risk benchmark, in addition to our peer portfolio,” said Mallick.

Teck has a different approach. It stress-tests every couple of years as part of optimization exercises, but “with a small staff, we’d rather spend our time on a few other things that would bring more value to the company” said Fechter.

“The challenge is always with the data,” Troy added. She explained that the HRM pension plan is using proxies for its private investments, which can lead to inaccurate risk measurement.  In our case, our risk system  is currently overstating market exposure, which isn’t a bad thing,  since we are being more conservative from a risk perspective.  Actual market exposure is less.

Q: What are the challenges with using factors?

“Monitoring can be a challenge,” acknowledged Fechter, noting that it took almost two years to educate the executive committee on board and train it on the plan’s low-volatility strategy.

“From a monitoring perspective, risk decomposition doesn’t line up with performance,” said Mallick, explaining that the challenge for Teck is communicating risks that don’t add up, such as the currency risk factor. He added that hedge fund mandates can also be an issue.

“From a monitoring perspective, risk decomposition doesn’t line up with performance,” said Mallick, explaining that the challenge for Teck is communicating risks that don’t add up, such as the currency risk factor. He added that hedge fund mandates can also be an issue.

Troy agreed. “Because it’s so complicated, I don’t bring this level of detail to the Pension Committee,” she said, explaining that they review traditional asset classes, which capture some high level exposures, but not detailed factor exposures. “It just comes back to the data. That’s the biggest challenge.”

Q: How can factor-based investing elevate the discussion on risk?

Mallick said OPG has created risk tolerance guidelines, which means the board isn’t required to be experts on the plan’s strategies. However, he added, factor-based investing has “opened us up from a transparency perspective.”

For Teck, factors are really part of an ongoing discussion around risk in the portfolio. Fechter explained how the plan has tried to move the discussion to governance—why it uses certain asset classes or different styles, the funded ratio and how to manage it—rather than whether to hire or fire a particular manager. “We’ve tried to elevate the discussion through this whole education process,” he said.

“I keep it very, very high level,” Troy added, explaining that it’s more important for the Pension Committee to understand the probabilities of not meeting their objectives rather than the detailed factor exposures.

Q: How did you educate your board?

Since 2008, Teck has had both board and executive turnover and has used it as an opportunity to get the new individuals up to speed, explained Fechter. And when it comes to education, simplicity is key. “We stay as far away from technical jargon as we can. We never refer to it as tracking error; it’s, how far away from the benchmark are we?” he explained, adding, “I’d suggest using simple language and small, topical pieces.”

For OPG, training is a multi-phase process. Mallick said there were pension committee meetings held almost weekly over a five-month period to look at aspects such as portfolio construction, investment philosophy, etc. In addition, the company worked with large-scale investment managers to offer education on specialized investment topics, such as hedge funds. “That allowed us to leverage those partnerships.”