De-risking – more than just reducing equity risk

June 2018

Many retirement schemes in the region are closed or mature, and facing the prospect of negative cash flows. When a scheme enters this part of their life cycle, Trustees typically consider ways to safeguard asset values and to reduce exposure to short-term equity market risk in favour of more secure high-quality fixed income and cash flow generating investments. This process is known as de-risking and it can have implications for how the equity portfolio is structured and managed.

In our view investment committees must ensure that they are not looking at the process from a purely transactional level, and are instead considering the entire process, the effect on performance, fee value and its impact on risk/return diversification at the total portfolio level.

We believe key to this process is understanding manager diversification and its importance in the de-risking process.

Why is manager diversification important?

Firstly, it is important to clarify that we feel manager diversification can benefit a pension fund at any stage of its life, rather than only being appropriate for those looking to de-risk their equities portfolios.

As has been well-documented, the majority of active managers (80%1) tend to underperform in the long-run. A pension fund opting to place its equity mandate with one manager is, in effect, making a call on the portfolio positioning of a particular manager – whether that be sector, country, factor or otherwise – and therefore leaving itself exposed to significant performance and manager-specific risk, noting that for all managers, there are inevitably times when the manager’s style is out of favor. In our opinion, a multi-manager approach can often offer institutional investors the most advantageous solution in terms of structure, returns and risk over the entire market cycle.

Our firm view is that such a well-diversified multi-manager structure containing managers that each bring their own approach, style, philosophies and drivers, increases the chance of outperformance while the chances of potential underperformance fall away.

The impact of de-risking

One of the primary issues facing a pension fund on its de-risking path is that they tend to be under-diversified at a manager level, particularly on the equities side of a portfolio.  We believe a typical approach to de-risking will tend to exacerbate this issue, as can be seen in the following example.

Icon: clipboard with checklist

Take a hypothetical retirement scheme with US$200 million in its equities portfolio, distributed equally across four managers ($50 million each). As the scheme looks to de-risk its portfolio, it may look to take $50 million out of equities. The most common question in this scenario is which manager to fire?

Investors might choose to get rid of the most expensive manager or the best/worst performer. In our view, the big issue here is not how to choose which manager to fire, but to understand that firing any manager reduces the diversity in the portfolio that a diversified multi-manager structure can give you, and therefore reduces the probability of the remaining active equity portfolio outperforming.

The following chart is extracted from our paper, Portfolio matters: Losing at the singles game, and shows that the larger the number of managers in the portfolio, the less volatile the returns will be, and the greater the likelihood that the portfolio outperforms its benchmark.

Number of managers increases with lower spread of returns

Number of managers increases with lower spread of returns

Source: Willis Towers Watson

Instead of asking which manager to fire, a more appropriate question might be “can we reduce the mandates held across all managers?” Yet we find that this still yields a negative outcome when wider factors are considered.

A smaller mandate will often be less efficient for a scheme from an overall cost and fees perspective, with the asset owner losing firepower in negotiating better rates with a manager. Additionally, mandate sizes might fall to a point where the retirement scheme is asked to switch from a separate account into a pooled fund, which can make sense, but will incur transaction costs.

If neither of these options are palatable, it is not beyond the realms of possibility for a plan to see its equities strategy end up in a passive vehicle, where alpha generation is eradicated and potential for better returns is lost.

With all of the options presenting downsides to the retirement scheme, this is where we believe a multi-manager fund structure can prove effective as it allows access to different styles and views on the market, while at the same time removing the challenges faced when reducing the equity allocation. Now the retirement scheme can redeem units in the pooled fund and avoid having to fire a manager and therefore reducing the diversification of the equity portfolio. It also proportionally reduces the allocation to the underlying managers, while not having to worry about breaching minimum sizes or significantly increasing fees.

Conclusions

In summary, we believe that de-risking is a great outcome for a pension fund, but pension committees must take into account the significant impact of rising costs and falling diversity within the de-risking flightpath if they are to truly achieve the best outcome for members.

While historically a traditional de-risking plan may have focused solely on the release of money from riskier assets, as our knowledge of the risks and rewards of that diversification has grown, so has our understanding of how best to structure portfolios in order to maximize their performance.

In our view, multi-manager fund structures can offer pension funds an option that mitigates many of the disadvantages attached to de-risking, particularly around manager diversification and cost efficiency. pension committees may therefore wish to consider this range of strategies more closely when devising a more robust de-risking plan, in order to ensure they meet all their objectives in the most effective and low-risk way.

Further information

For further information, please contact your usual Willis Towers Watson consultant or email:
investment.solutions.asia@willistowerswatson.com

The contents of this article are for general interest. No action should be taken on the basis of this article without seeking specific professional advice.

About Advisory Portfolio Group Asia

Willis Towers Watson has a series of Advisory Portfolio Groups (APG) within the Investment line of business around the globe, based in the Americas, Asia, Australia, the UK and EMEA. The APG in Asia seeks to identify and develop best ideas and approaches that can offer a competitive advantage to Asian institutional investors, while spearheading Asian-focused investment research and portfolio construction advice. Further, the group is responsible for ensuring high quality and consistency of advice, and works with client teams to design portfolios.

This paper was written by members of the APG for general information purposes only.

Edited and reviewed by:
Paul Colwell, CFA
Head of Advisory Portfolio Group, Asia