In the CFA Institute’s new Investment Performance Measurement newsletter, launched this month David Spaulding, president The Spaulding Group, and Steven Stone, partner at Morgan, Lewis & Bockius discuss the issues concerning the use of theoretical performance, summarise the regulatory implications and risks of using such presentations, and suggest best practices and appropriate disclosures.
Canada’s ministry of finance will begin public consultations on the legislative and regulatory framework for federally regulated private pension plans in mid-March.
Defined contribution company plans began 2009 on the heels of a bruising year. The significant decline in capital markets coupled with extreme investment volatility raises many issues for companies with DC plans. There are numerous issues employers/plan trustees need to address when reviewing their plans this year. These range from the plan’s governance to the choice of low-risk investment options. Mercer’s Dublin office has prepared a 10 point plan that employers and trustees could potentially adopt as they re-evaluate their DC plans and related responsibilities in 2009.
- Review the adequacy of DC benefits and consider whether current pension provision is meeting employees’ needs. Economic conditions and future expectations have changed considerably since many DC arrangements were designed. Depending on their ages and time horizons, members may need to adjust their expectations of retirement income. Employers may also need to assess the workforce management implications.
- Review DC provider performance. The market for DC provision has evolved with new providers and products entering the market while others exit. Trustees should consider if the existing arrangements continue to meet the investment needs of all members and if performance continues to meet the objectives set when selected.
- Review the suitability of investment options. Poor investment choice is likely to be one of the main issues impacting members’ benefits and trustees should consider the current options available to members in light of new industry developments. If the investment range has not been reviewed for some time, consider the membership profile, how this might have changed, how members are making investment decisions and whether the existing range includes a facility for members to manage their investment needs over time.
- Review the default investment option. A feature of most DC plans is that the majority of members “end up” invested in the default option; this makes it crucially important for trustees and members. Is it effective in varying investment conditions and over time for members’ changing investment needs? Does it protect members who are close to retirement from annuity risk or market risk, while at the same time catering for members with longer time horizons? As DC schemes develop, the member population becomes more diversified, and consequently the existing default option may no longer cater for all groups of members. There may also be an opportunity to improve the efficiency of the default option (in terms of the risk/reward trade off), given the wider range of investment vehicles now available.
- Monitor the choices being made by individual plan members (not in aggregate). Review individual member asset allocations and/or individual members’ rates of return. This type of review can provide good insight into whether your DC plan is working, and can point out areas for improvement, such as member education or fund choices.
- Assess the effectiveness of your member communications strategy. This is a good time to revisit financial and investment education. Given the market turbulence and economic uncertainty, what information should be provided to plan participants?
- Review and revise your plan’s Statement of Investment Policy Principles (SIPP). In the current market environment, fiduciary risk is high and a review of the SIPP can help minimise this risk.
- Ascertain if your plan members are engaged at all. Are they knowledgeable about their savings and retirement plan choices? Given the recent market volatility and economic turmoil, this is a good time to revisit engagement and education about investing and retirement planning. Larger employers/trustees may wish to consider focus groups to find out what members see as their challenges, education needs and barriers to understanding.
- Assess what kind of retirement income or replacement ratio employees can expect from the plan. If this is projected to be lower than previously expected, action is required sooner rather than later. Consider revising the scheme design, allowing additional member contributions, or reinforcing the importance of saving more outside the plan in order to secure a comfortable retirement for members.
- Review the stability and risk exposures of investment managers in light of the current economic turmoil. Consider the status of the plan’s investment managers(s) and their commitment to continue to develop their offerings to meet member needs.
Alternative asset investors, particularly hedge fund investors, must remember that investment performance of an asset manager should never be the sole or even primary consideration when making an investment decision. In fact, during recent years, qualitative factors have been the root cause of failure for nearly half of all hedge funds that have experienced forced liquidations.
In evaluating alternative investment managers, prospective and existing investors must consider the overall due diligence process as an integrated three-ponged approach in which risk-reward analysis is combined with investment thesis review as well as operational due diligence. This paper, by Ennis Knupp & Associates, provides investors with a top10 list of critical questions to ask when assessing hedge fund managers.
For institutions with access to professional advice and with long investment horizons, a fixed mix approach to asset allocation is “aiming too low”, according to Jeremy Grantham, outspoken chief of GMO, who argues instead for a more dynamic approach to asset allocation in times of severe mispricing.
“If the last 15 years has taught us anything, hasn’t it taught us that asset classes can be incredibly mispriced, along the lines of the 35 times inflated earnings for the S&P in 2000? Why would you ignore these opportunities to sidestep trouble?” Grantham ponders in his latest quarterly letter.
Grantham says it is sensible to be fairly static when pricing is normal, or even half way normal, but when very large mispricings occur, he asks whether it is more reasonable to move away from extremely overpriced assets towards more attractive ones.
“Markets are very mean reverting over longer horizons, and sophisticated clients always proclaim their patience,” he says, arguing that asset allocation based on serious action at the extremes and inactivity the rest of the time has a good record and can be done quite simply.
GMO puts its money where Grantham’s mouth is. Over the past 16 years, more than 60 per cent of the total outperformance and more than 60 per cent of the reduction in volatility in its global balanced asset allocation strategy has come from moving the mix of assets, rather than implementation.
“Asset allocation is simply much easier than adding alpha to a fund, since there is more to sink your teeth into,” he sys. “Counter-intuitively, asset classes are more inefficiently priced than stocks.”
Grantham says there is a large and relatively efficient arbitrage between stocks, and the career risk of picking one stock versus another is quite modest, but in contrast when picking one asset class against another it is very clear when mistakes have been made.
“This immense career risk makes it likely that there will always be great inefficiencies, for investors are reluctant to move money across asset boundaries. Consequently, there is great advantage to be had in getting out of the way of the freight train, rather than attempting to prove your discipline by facing it down. The advantage is in both higher return and lower risk.”
Diminishing returns from many hedge funds and the Madoff fraud have caused institutional investors to intensify their due diligence on hedge funds, and demand more liquidity, transparency and lower fees, according to research from alternatives specialist Preqin.