How to Kill a Black Swan Remy Briand and David Owyong ...

Mangiero: People are more sensitive about leverage in
lots of different forms: short-selling, margins, derivatives,
portfolio construction.
We hear a lot of pension investment decision makers
say, “Well, our investment policy statement”—assuming
they have one—“prohibits the use of leverage.” But then
you ask them a lot of questions about what instruments
they’re holding, and at the end of the day, usually they’re
holding some kind of security or have monies allocated to
funds that are using derivatives or securities that embed
derivatives. We tell institutional investors that the bottom
line is it’s going to be almost impossible to escape
exposure to leverage in some fashion. But, in the aftermath
of the credit crunch, we think at least that people
are looking at leverage.
Another issue that has come up, with respect to the
credit problem, has been that some investors had put
their money in what they thought were very liquid, relatively
clear-cut “low-risk” investments. And now they find
that some of those clear-cut “low-risk” funds have been
investing in short-term asset-backed securities or things
that were anything but low risk. There are some lawsuits
related to that, alleging that those asset managers and
some of the service providers, like auditors, did not really
vet the true economic risks associated with what was
inside the portfolios.
JoI: How did the liquidity crunch impact interest rates and
how did that impact pension plans as a result?
Mangiero: For a while, as the government kept trying to
depress interest rates overall by adding liquidity to the
market, reported pension liabilities increased. In the aftermath
of the Pension Protection Act of 2006, this was a big
deal for many companies that suddenly found themselves
in a position of being statutorily underfunded.
As a result, more than a few employers found themselves
having to accelerate cash payments to their pension plans
to restore funding normalcy. Now there are quite a few U.S.
corporations seeking relief from the Pension Protection
Act, saying, “Our stock has been hit so hard, and we don’t
want to spend billions of dollars to top off the pension plan
because of short-term issues, and we’re fine in the long
term.” Preceding the central banks’ intervention, crisis conditions
meant a rise in LIBOR. This resulted in higher costs
for pension plan swap floating-rate payors.
JoI: Does the surge in correlations among different asset
classes during times of market crisis have any impact on longterm
planning?
Mangiero: I think the answer would have to be yes. It just
depends, in part, on how pension plans respond. If the
immediate response is to sell positions as correlations
start to converge, the pension plan manager could incur
transaction costs and lock in losses. 401(k) plan participants
encountered the same problem.
Then there is the issue of strategic asset allocation. If
investors do change the short-run mix, how is that likely to
impact long-term performance?
I don’t think most investors had anticipated the flight
to quality that we experienced in the fall of 2008. For
example, if a pension plan had allocated money—and here
I’m talking more about a defined benefit plan—let’s say,
to a hedge fund that was investing a lot in equity, and
the pension plan also had X percent allocated to a longonly
strategy, and the equity market tanked, then all of a
sudden the defined benefit plan is going to see its total
portfolio drop in value from, not only the long equity allocation,
but also the hedge fund allocation. I think many
investment decision makers were just not prepared for
that. It was kind of like a doubling-up, or worse, of the
exposure to some things that were not doing well.
It’s a very tough time for people. The good news is—
and this is what we’ve been encouraging, urging pensions,
endowments and foundations to do—that people can use
this time as an opportunity to focus on risk management,
learn lessons, ask lots of tough questions, make changes
now and hopefully improve the process. There are some
folks who are doing a great job already. But again, the best
defense is a good offense—in terms of risk management,
just getting a very robust process in place. We are seeing
more pension plans starting to consider [using] or just
outright hiring risk managers. And I think that’s a wonderful
step in the right direction.
JoI: Can you talk about how you see benchmark risk, and
what the most critical issues are for pensions to consider in
that area?
Mangiero: That’s a great question. It’s also one that’s difficult
to answer. For example, consider liability-driven
investing, a hot topic in the pension community. I ask a lot
of pension plans the question, “How are you benchmarking
the LDI managers?” And the answer I usually get back is,
“We’re not sure how to do it yet.” Some people are using
a pension surplus-at-risk measure, as opposed to value at
risk. And some people are looking at a deviation around a
cash flow benchmark.
I think for those involved in indexing, there’s a great
opportunity to help the retirement-plan decision makers with
thinking through what the benchmarks should look like.
JoI: Final thoughts?
Mangiero: I think retirement-plan decision makers are
faced with many challenges, whether you’re talking about
defined contribution or defined benefits. There’s almost
no relief. There’s not a one-size-fits-all solution to which
everybody can gravitate and try to make up for losses,
try to protect themselves from losses down the road. The
best defense, we think, is just having a really good process
in place, so that you can identify risk drivers or risk factors,
maybe before things get out of hand.
www.journalofindexes.com
July/August 2009
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