By Patrick J Schena
As the global financial crisis rises in the rearview mirror, investors ponder its longterm effects. Many equity markets globally have recovered to pre-crisis levels, while slow economic growth has prompted central bankers – led by the U.S. Federal Reserve – to reconsider their liquidity programmes. This has shaken fixed income and equity markets alike, suggesting that impacts of the crisis are still within sight.
After five years and countless behests to “rethink,” the quest for performance remains elusive. Succeeding in this environment demands a disciplined core, innovative thinking and the flexibility to be factor-curious, liability-sensitive, liquidity- selling, agency-aware and capacity building.
Factor-curious
An increase in alternative investing and experiences of the financial crisis have heightened interest in investment models that focus on risk factors across asset classes. Despite the intellectual appeal of such models, we find that few institutional managers have formally adopted them. A widely reported study1 on Norway’s pension fund found that 70% of all active returns since inception in 1998 could be explained by exposures to various systematic factors. The report recommended that Norway use a more top-down approach to strategic and dynamic factor exposures, but Norway has not yet acted on this advice. Instead of broad adoption, managers are experimenting with factor models on the margin.
Liability-sensitive
Few institutional managers are worry-free of liabilities and funding shortfalls. To address the funding gap, pension managers have demonstrated a greater propensity to use liability-matching investing strategies. Globally, nearly 50% of pension managers report actively using forms of asset-liability matching. However, constraints imposed by fluctuating interest rates and increased asset price volatility present acute challenges for all institutional investors. For some managers, this may warrant a formal liability driven investment (LDI) programme. Structuring liability management into the broader framework of overall portfolio risk allows for a more holistic approach to risk management.
Liquidity-selling
Institutional investors are well positioned to take advantage of long investment horizons to sell liquidity and harvest liquidity premia. However, their approaches must better monitor and forecast not only the liquidity requirements of their stakeholders, but also the levels and price of liquidity offered by individual asset classes. This includes defining their optimum allocation to illiquid assets and incorporating liquidity premia into benchmarks, which helps in reviewing managers’ active harvesting of liquidity through performance attribution models.
Agency-aware
Allocation strategies with a heavy use of alternatives can expose a fund to a variety of agency issues associated with “outsourced” investments. Continually examining performance-based incentives can yield effective constructs that compare active investment strategies to the broader risk-return objectives of institutional portfolios. However, this requires active monitoring of performance-based compensation relative to both return objectives and liquidity needs to effectively align the interests of asset owners and alternative managers.
Capacity-building
To be successful, managers must assess institutional gaps and be prepared to continually retool capacity in portfolio analysis as well as risk and liability management. This requires creative approaches to developing capacity for leveraging best practices between asset owners and managers. Co-investing strategies and partnerships between asset owners and managers that actively promote knowledge and skills transfer will help illuminate the way ahead.
The way forward
Factor-based risk models are not a panacea, but can help enhance risk-adjusted performance. Liability management strategies must be incorporated holistically into the broader framework of managing portfolio risk. Harvesting liquidity premia can be valuable, but comes with a cost; and finally, investors must be cognizant of agency costs and be prepared to build capacity in their current quest for performance.
Patrick J Schena is adjunct assistant professor of international business relations at the Fletcher School, Tufts University and Nidhi V Shandilya is is assistant vice president at State Street’s Center for Applied Research
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