Pension fund managers need to fundamentally rethink their attitude to risk management, according to Bob Litterman, head of quantitative resources for Goldman Sachs’ investment management division in New York. Delivering the keynote speech at the start of Risk’s 2003 Quant Congress conference held in New York last month, Litterman slammed pension fund managers for taking an over-simplistic approach to matching assets and liabilities.
Managers had gambled on equities as a way of meeting long-dated liabilities and failed, but simply switching to bonds was not the answer. “There need not be tension between bonds and equities,” Litterman said.
The risk in investment portfolios, argued Litterman, comes from three very different sources. First are interest rate risks incurred as a result of long-dated liabilities. These should be hedged separately using interest rate swaps rather than the purchase of bonds, to minimise capital requirements. Then there is beta, or market risk present in the portfolio. “That’s available for free,” said Litterman. Investors needed to be careful not to pay active managers for achieving passive market exposure when futures or exchange-traded funds were available for doing this.
The third risk Litterman highlighted is active risk, or alpha, which he said is currently under-utilised by pension fund managers. With the equity risk premium as low as 3.5%, said Litterman, corporate pension funds that bet heavily on equity markets could not meet their levels of targeted returns without leveraging their equity exposure – which increased volatility. Unable to reduce targeted returns without incurring the wrath of credit rating agencies and analysts, the only escape from this trap was to take active risk.
If markets were efficient, active returns would be zero. But markets were not efficient, Litterman said, recalling how the late Fischer Black – deviser of the Black-Scholes model for pricing options – said he only realised this after becoming a practitioner, working for Goldman Sachs. However, achieving pure alpha exposure is not easy, Litterman cautioned. To get the full diversification benefit, the active return in a portfolio needed to be uncorrelated with the market, which made market-neutral hedge funds a particularly suitable investment choice. These investments should be optimised using an information ratio measure, he added. Unfortunately, capacity is limited, as the best hedge funds are usually closed to new investors. Capital was another important constraint, Litterman said, and he suggested overlay strategies as particularly efficient in this respect.
Derivatives play an important role in managing these three risks, suggested Litterman. The cheapest methods of gaining market risk or beta exposure were often derivatives-based. As for active risk, overlay strategies, such as currency overlay and global tactical asset allocation, required derivatives to work. One example given by Litterman was the ‘Stocks Plus’ product offered by US fund manager Pimco, which overlaid active fixed-income fund returns on to an S&P 500 portfolio.