Active Management Or Equity Risk Premium

Active Management or the Equity Risk Premium: Place Your BetsInvestment Risk Working Party Finance and investment Conference 22-24 June 2003... ‘Where they believe active management to h

Active Management or the Equity Risk Premium:

Place Your BetsInvestment Risk Working Party

Finance and investment Conference

22-24 June 2003

A Perfect Storm?

● Market-based valuations

● Weak equity markets

● Greater trustee accountability

● Media highlighting pension disasters

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.’

‘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

● Merits of strategic and active risk

● Rationale for current split

● Tailoring the split of risk

● “Unconstrained” mandates

Background definitions

● Investment Risk

● Minimum Risk Position

● Strategic/Market Risk

● Active Risk

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)

Risk return trade-off: Market risk only

STRATEGY TOOL KIT

change market risk pursue active management

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

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

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

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

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?

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

Unconstrained mandates

● Focus on long-term

● Less turnover

● Index weightings ignored

● Genuine active management

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…