Linking Benchmarks, Risk Budgets and Compensation:

Transcription

1 Linking Benchmarks, Risk Budgets and Compensation: A Story Based On Ontario Teachers Pension Plan s Experience ICPM, October 24 th, 2006 Barbara Zvan VP, Asset Mix & Risk

2 2 THE BEGINNING: THERE WAS BOB Bob Bertram CIO, Ontario Teachers Pension Plan CFA BA at the University of Calgary MBA at the University of Alberta 18 years experience at Telus Corporation Baron of Sealand Timothy s Coffee Trivia Legend

3 3 CIO S & INVESTMENT DIVISION S GOALS Manage the Fund as a business. First meet our liabilities, then add value. Incremental risks must earn incremental returns. All systems must be aligned to those goals.

4 4 MEET TWO PORTFOLIO MANAGERS: BEN & RICK BEN Bob only has 2 portfolio managers Each have the same amount of assets at the start of their mandates Manage their portfolios independently Same benchmark In terms of rate of return RICK

5 5 THE PLAN S VALUE ADDED TARGET: 0.5% OVER THE BENCHMARK Bob was targeting 0.5% over the Plan s benchmarks Looked reasonable with respect to what the other funds were stating Did not have full confidence he could achieve this target over the long-term

6 6 BOB FOUND A FEW CHALLENGES Difficulty understanding his portfolio managers guidelines Many do s and don ts & limitations/restrictions No effective means of monitoring Difficulty understanding the size of the bets & range of outcomes to expect Even more difficult when portfolios are combined Compensation is based on value-added in terms of rate of return Difficult to increase size of mandates

7 7 BOB S SOLUTION: A RISK SYSTEM A risk system is a calculator that will provide information on the range of outcomes Portfolios analyzed in isolation, combined with others and altogether for total fund reporting Enables returns to be analyzed in terms of how much risk was taken

8 8 A SHORT STATISTICS REVIEW: WHAT IS A DISTRIBUTION? Most of the time, a manager will achieve a return somewhere near their stated benchmark However, the manager will sometimes really underperform or outperform This variability about what the value added will be can be summarized by a distribution In finance, the normal distribution is often used

9 9 SHORT STATISTICAL REVIEW Variability of return around the mean => volatility For a portfolio with a volatility = 1%, the vast majority of returns relative to its benchmark will range from -3% to 3%

10 10 SHORT STATISTICAL REVIEW For a volatility of 2%, the vast majority of value added returns would range from -6% to 6% The larger the volatility, the greater the chance for higher outperformances & greater likelihood of larger underperformances => the higher the risk

11 11 TARGETED RETURN ON RISK FOR THE TOTAL FUND = 25% Bob s compensation goals: Reward managers if total fund outperformed its benchmark Calibrate the return to reflect the risk of suffering large losses against their benchmark Bob s risk level = the loss relative to the benchmark that could happen with a 1% chance = 2.6 x volatility Target bonus earned as soon as positive relative to the benchmark Maximum bonus when return is in top 25% of its possible range of returns = 0.65 x volatility At the fund level, the targeted return on risk is 25% [=(0.65 x volatility)/(2.6 x volatility)]

12 12 BOB S NEXT CHALLENGE: BEN & RICK Ben & Rick s compensation goals: Expect to be compensated on their own portfolio s performance Need to incorporate diversification

13 13 DIVERSIFICATION SIMPLIFIED: A COIN TOSS GAME One Coin Toss OUTCOMES $1 50% chance 50% chance $2 $0 (100% return) (-100% return)

14 14 DIVERSIFICATION SIMPLIFIED: A COIN TOSS GAME Two coin tosses 2 TOSSES OUTCOMES 50% chance $1 $2 25% chance Coin Toss #1 $ % chance 50% chance $0 $1 $1 $1 25% chance 25% chance $1 Coin Toss #2 $ % chance $0 $0 25% chance

15 15 DIVERSIFICATION SIMPLIFIED: A COIN TOSS GAME Three coin tosses Each risking $0.33, you have a 12.5% chance of a $2 outcome and a 12.5% chance of losing all your initial $1 Four coin tosses Each risking $0.25, you have a 6.25% chance of a $2 outcome and a 6.25% chance of losing all of your initial $1 Increasing the number of sources of return (each coin toss), lowers the likelihood of an extreme event (gains & losses)

16 16 COMBINING VOLATILITY: FOR TWO PORTFOLIOS Volatility of combined portfolio = Square root of the number of portfolios x Volatility of underlying portfolios (all assumed to be the same) Volatility of total fund = 1.4 x Volatility of Ben s & Rick s portfolios But what if there are more than 2 portfolio managers?

17 17 COMBINING VOLATILITY: FOR MORE THAN TWO PORTFOLIOS If Bob had six diverse managers, he could allocate 41% of the fund s risk to each manager and his/her return or risk target would only be 10%

18 18 JOB DESCRIPTIONS QUICKLY POSTED BEN RICK Bob immediate put up job postings to triple his current staff of 2

19 19 NEXT STEP: COMMUNICATION To communicate this investment plan, Bob created the risk budget Summarizes the risk levels and the dollar value-added targets for the fund and each of the managers Target of 0.5% above benchmark implied a risk budget target level for the fund Each year, Bob would analyze his various programs and the investment environment to decide how much risk will be budgeted to each manager

20 20 NEXT STEP: MEASUREMENT Implement a risk system Understand how much risk each manager was taking relative to what had been budgeted to them Understand how much diversification existed Understand risk being taken at the fund level Other benefits of a risk system Redesign his managers portfolio guidelines to remove a number of the constraints Design a monitoring system Ms. VAR

21 21 A YEAR LATER: RISK SYSTEM IS OPERATIONAL BEN RICK BENCHMARK HUGGER RISK TAKER Bob was in shock Little chance 0.5% target would be achieved Not enough risk being taken

22 22 BEN THE BENCHMARK HUGGER BEN BENCHMARK HUGGER

23 23 RICK THE RISK TAKER RICK RISK TAKER

24 24 BOB IN NEED OF A SOLUTION

25 25 THE SOLUTION: LINKING THE RISK BUDGET TO COMPENSATION Link the risk budget that formulates the value added targets for each manager to the compensation system To encourage long-term focus, compensation would be based on performance over a fouryear period Risk and return targets changed to dollars vs. a % return Rick quickly agreed to accept the additional mandate

26 26 A FEW YEARS HAVE PAST How have things worked out for Bob?

27 27 JOB POSTINGS QUICKLY FILLED RICK RICK Y. RICK O. 6 active managers 5 focus on producing value added RICK T. RICK P. RICK B. 1 responsible for private investments

28 28 DESIGNED ROLE FOR INDEX MANAGERS BEN BEN D. 2 index managers 1 for physical holdings 1 for the derivative overlay program

29 29 STRATEGY DEPARTMENT WAS CREATED Ms. VAR Strategy department Help Bob with increasing complexity Coordination of portfolio managers and risk being taken at the fund level Oversees portfolio guidelines

30 30 OTPP INVESTMENTS CEO and Board of Directors Strategy and Research Pension research Asset research & creation Asset/Liability Modeling Total fund strategy Total fund optimization Return Factories Asset specialization Selection Acquisition Management Asset class specialization Markets Optimization strategies Operations & Services Finance, Systems, Law, Audit Generate/consolidate inform n Support all levels Facilitate efficient operations Manage control systems OTPP Investments

31 31 AN OBSERVATION: CASH BENCHMARKS BECAME POPULAR 5 out of 6 active managers changed to a cash benchmark With approval of Bob & the Board of Directors Use very little net assets An example of cash benchmark is a 3-month Bankers Acceptance or CDOR index Managers primarily focused on value added actives prefer to construct their portfolios as long-short Can clearly see their bets Risk can be measured Performance stated in dollars only

32 32 A LITTLE MORE TIME PASSES: HOW HAVE THINGS DEVELOPED? Staff has increased dramatically 150 investment staff 75 investment finance staff 75 investment IT support staff With each passing year, Bob has increased the size of each department s risk budget, which means their value added targets have increased. Each department is headed up by a Rick The Bens now report to the Ricks Bob now sees benchmarks as a means to allocate responsibility E.g. Cash benchmark implies just add value don t worry about maintaining market exposure

33 33 VALUE ADDED TARGETS: STARTING IN 1999, SET THROUGH RISK BUDGETING PROCESS 1.6% 1.46% 1.4% 1.2% 1.29% 1.29% 1.34% Management Value Added Targets After Cost (5x Factor) 1.0% 0.8% 0.6% 0.51% 0.66% 0.91% 0.99% 0.4% 0.2% 0.0% Year Introduced thresholds based on return on risk capital (first risk budget)

34 34 6.0% 5.0% RISK USAGE: MOVED WITH THE VALUE ADDED TARGETS 1.6% 1.4% 1.2% Integrated Market & Credit Risk reporting began January % 1.29% 1.29% 1.46% 4.0% Active Risk 3.0% 1.0% 0.8% 0.66% 0.91% 0.99% 2.0% 1.0% 0.6% 0.4% 0.2% 0.51% 0.0% 0.0% Introduced thresholds based on return on risk capital (first risk budget)

35 35 HISTORICAL PERFORMANCE: REFLECTS SKILL USING RETURN ON RISK BUDGETED Section POOR PERFORMANCE Normal Distribution Targeted 25% Return On Risk Yr = STRONG PERFORMANCE Actual Return (Risk Budgeted/2.6) Historical Performance Reflects Skill (6.0) (5.0) (4.0) (3.0) (2.0) (1.0) Assumes 0.34% as a cost allowance since 1990, Prior to 1999, 5x Value Added Target After Costs equals the 1999 value of 0.51%

36 FOUR RETURN-ONLY PEER COMPARISONS: DESCRIPTION OF SURVEYS SURVEY SPONSOR PEER DESCRIPTION DATA ISSUES 145 Defined benefit pension plans who arre PIAC members Sizes: $27M - $122B 13 Plan sponsors Sizes: $7B - $127B Section 2 Composition of funds reporting vary over time (low returns not submitted, creating an upward bias) OTPP second largest fund Active risk is not reflected, no adjustment for different asset mixes CEM Small sample group Pooled funds of 60 inv t management firms. Value of pooled funds > $160B Before managers fees 46 Funds classified as Balanced Same firm represented many times as mandates differ by client Survivorship bias; clients terminate mandate after poor performance Active risk is not reflected, no adjustment for different asset mixes

37 37 ILLUSTRATION: UNDERSTANDING THE GRAPHS Section 2 Rate of Return (%) st Decile or 90 th Percentile 1 st Quartile or 75 th Percentile Median or 50 th Percentile 3 rd Quartile or 25 th Percentile 10 th Decile or 10 th Percentile 10% of all the funds surveyed, reported a return above 9.7% 10% of all the funds surveyed, reported a return below 6.7% 25% of all the funds surveyed, reported a return above 9.1% 25% of all the funds surveyed, reported a return below 7.3% 50% of all the funds surveyed, reported a return above 8.1% 50% of all the funds surveyed, reported a return below 8.1% Peer Group

38 38 PEER COMPARISONS: FAVOURABLE ON A RETURN BASIS 4 YEAR COMPARISON th Actual Return Section th 90th 95th Rate of Return th 10th Benchmark Return Return Type: Actual Only 9 peer funds had a 4-year history Actual Policy/ Benchmark 5th Actual 5th Actual

39 39 CEM s RISK-RETURN ANALYSIS: HORIZON HAS BEEN EXTENDED TO 10-YEARS 6% 5.6% Section 2 5% 4% 4.2% 4.0% 4.4% 4.1% 4.5% Value Added Return 3% 2% 1% 0.9% 1.3% 2.1% 0.9% 3.0% 2.7% 2.3% 0% -1% -2% -3% -0.3% -0.1% -2.0% July (annualized) -0.2% Ten-year Horizon Started Measuring Active Risk Introduced thresholds based on return on risk capital (first risk budget)

40 40 CEM s PEER COMPARISION: STILL FAVOURABLE ON A RISK & RETURN BASIS Section 3 OTPP still performs well relative to CEM s entire universe when comparing risk-adjusted returns

41 41 BOB IS PLEASED WITH HIS PAST PERFORMANCE The strategy presented was a vision of Strategy 2000 Bob is already planning Strategy 2020

42 Barbara Zvan VP, Asset Mix & Risk 5650 Yonge Street Toronto, Ontario M2M 4H