Active Management or the Equity Risk Premium:Place Your Bets

Investment 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.’

Barry Riley, Financial News 5th May

‘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

Overview

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

Market Risk 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 EX

PEC

TED

RETU

RN

Risk return trade-off: Typical pension fund

EX

PEC

TED

RETU

RN

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 strategiesand your expected risk-return (Sharpe

ratio) of asset classes from your strategic

asset allocation analysis

EX

PEC

TED

RETU

RN

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…..