Putting an effective Risk Management Plan in place POA Winter Conference L Moabi, 31 May 2010

Transcription

1 Putting an effective Risk Management Plan in place POA Winter Conference 2010 L Moabi, 31 May 2010

2 Agenda What is risk management? Investment governance defined, why is it important? Risk Budgeting process How much risk is my fund taking? Is it appropriate amount? Where the risks should be taken to produce better return? Measuring & Monitoring Risk, what should I as a Trustee be looking for? Case Study

3 1. Risk Management explained

4 Good Governance Circular PF 130 requires Trustees to effect a risk management plan

5 What is risk management? Identification, analysis and classification of uncertainties is known as risk management. Classification will be generally acceptable risk, riskstobemitigatedand risktobeavoided. In general terms, risk management is the process of measuring, or assessing risk and then developing strategies to manage the risk.

6 Risk Management Process Risk Identification Communication Consider how to manage risks Monitoring process/ controls Process & controls

7 Indentifying key risks facing Trustees Governance Communicatio n Administration & Financial Death Benefit Distribution Risks Legal Risk Benefits Actuarial Investments

8 2. Investment Governance

9 Investment governance defined Pension fund governance regulates key players and governing documents that define relationship between the board, fund members and beneficiaries, internal staff, external service providers and other stakeholders. Investment governance is process of optimising investment decisions within framework that is compliant with statutory and common law fiduciary duties Governance is about process, a decision and oversight structure A better process has a chance of leading to good outcome than a poorly designed process.

10 Investment governance Retirement fund as a business In vast majority of cases, running pension fund represents non core function, raising several challenges Trustees expected to manage a large balance sheet in context of multiple stakeholders and within constraints of legal and financial regulation Accountability blurred by responsibility both to beneficiaries & the employer Trustees time limited by other commitments.

11 Investment governance Governance budget The capability of the governance structure employed by the fund and how efficiently it is operating Measured by Sizeofresources-time Skill level of resources- expertise Structure of deploying these resources organisational effectiveness.

12 Investment governance Good pension governance is difficult to achieve Good governance requires Clear mission or guiding purpose Clear allocation of responsibilities, separate roles for governing (policy), executive (planning & strategy) and operation/implementation activities Sufficient skilled resources Efficientuseoftime Transparency of actions.

13 Investment governance Monitoring Mission & Governance Implementation Setting risk budget Manager selection Strategic asset allocation Manager structure

14 Investment governance Governance Model Governance Fiduciary Objective setting Determine size of risk budget Monitor at macro level Executive Fiduciary Produce detailed risk budget Determine asset allocation and benchmark design Manager structure Manager selection and monitoring Operative Fiduciary Investment decisions Day to day fund management Custody

15 Investment governance Where many funds fall short Lack of clear accountability Trustees not sticking to decision framework emotional pitfall Complexity of investment strategy does not match understanding of members Over elaborate oversight reports Wasted time at board meetings.

16 Investment governance Mitigating governance risk Spend more time developing policy framework - clear mission or guiding purpose Trustees must understand and believe in it Sticktoframework,lettimeworkforyou Perform regular reviews, ensure framework still applicable Control emotions Communicate.

17 Investment governance Benefits of good governance Improves decision making Limits emotional pitfalls Efficientuseoftime Builds trust with members.

18 3. Setting a risk budget

19 Risk budget Trustees objectives Ensure security of members(accrued benefits) Grow capital Achieve high long term investment return Funds investment policy needs to reflect extent to which trustees arepreparedtotakeonriskinordertoaimforhigherreturns In practice pension fund sets its investment policy in two stages Trustees establish appropriate asset mix the strategic benchmark for the fund(strategic/ policy risk) Tactical implementation of strategy involves selection of manages and the appropriate level of risk they should take relative to the strategic benchmark(active or manager risk).

20 Risk budget The term risk budget is a process of establishing: Howmuchinvestmentriskistobetaken Isitanappropriateamountand Whereisitmostefficienttotakeriskitinordertomaximisereturn.

21 Risk budget Howmuchriskisyourfundtaking? In assessing how much risk the fund is taking, there are several ways of measuring risk including at looking at future funding levels, and contribution rates Risk budgeting is a framework for analysing both risk and return overshortandlongterm Key question: will the assets held likely to outperform the funds liabilities and what range of potential outcomes is Therangeofreturnscanbeestimatedbysimulatingeffectsofthese investment risks. - These expected outperformance and risk figures are called the risk budget.

22 Risk budget Howmuchriskisyourfundtaking? 10% Bonds. 90% Equities 30% Bonds. 70% Equities 50% Bonds. 50% Equities

23 Risk budget Howlargeshouldtheriskbe? Two critical points The quantum of return that can be produced from risk budget needs to be considered Taking any additional risk in a pension fund must be carefully justified( as the fund is not considered core activity).

24 Risk budget Determining strategic asset allocation Useful in maximising financial efficiency (IR) Alternative Assets Equities Provide safety to Fund Bonds

25 Risk budget Determining manager structure Active Satellite (Take more risk to achieve higher return) Active Core (Operate portfolios with wide diversification and low active risk) Passive Core (Offers stable returns over low level of active risk)

26 Risk budget Active (Manager) Risk Strategic Policy Risk Total Fund Aggregate Portfolio Bmark Total Fund Bmark Liabilities Portfolio A Bmark A Portfolio B Bmark B Portfolio C Bmark C Overall risk is the sum of strategic risk and active risk

27 Risk budget Research reveals that asset allocation is key driver of performance 4.60% 1.80% 2.10% 91.50% Asset Allocation Security Selection Market Timing Other Should funds employ more risk in policy structure or in the implementation (manager structure)?

28 Measuring and Monitoring risk

29 Types of risks Loss of Capital A common concern with any investment is that you may lose the money you invest- your capital. Referredtoasabsoluterisk Therecentmarketdeclinehasthoughtusthatitispossibletoloose significant amount of money in short period of time An entire series of statistical measures have been created to addresstheissueofdownsiderisk orriskofloss.

30 Types of risks Opportunity risk Opportunity risk is relative in nature defined as the possibility of underperforming a benchmark The benchmark can be generally accepted index, peer group benchmark or some unique benchmark created by the investor The bottom line is similar, investors hate to see other similar investments perform better than their own.

31 Types of risks Shortfall risk Usually measured against some future liability A pension fund may need to plan for an increase in pension liabilities based on actuarial projections Shortfall risk, is the risk of coming up short over a specific period of time All performance based risks are backward looking they are based on historical performance. They are meant to convey the probabilities of future behaviour based on the past As we know, probabilities do not equal certainty!

32 Measures of Portfolio Risk

33 Measures of Risk To create a numerical representation of risk, we often use variability of returns as a proxy for measuring uncertainty. By using the variability of an investment product s historical return stream, we can create a variety of statistical measures that will allow us to put performance into perspective.

34 Measures of Risk Alpha ( α ) Alpha is a beta-adjusted risk measurement. It measures the difference between the portfolio s actual return and the benchmark return.

35 Measures of Risk Beta ( β ) A statistic, which describes the volatility of a manager s return relative to the average fund or universe. It measures the sensitivity of the fund s excess return to that of the market portfolio. Abeta<1implieslowervolatility.Itisthesystematiccomponentof return, i.e. the extent to which the fund return moves in line with the benchmark return.

36 Measures of risk Return Histogram Asimplewaytomeasurethevarianceofreturnsistocreateahistogram Ranges Count % of Total >5% 21 32% 4% to 5% 5 8% 3% to 4% 2 3% 2% to 3% 1 2% 1% to 2% 6 9% 0 to 1% 3 5% -1% to 0 3 5% -2% to -1% 5 8% -3% to -2% 3 5% -4% to -3% 5 8% -5% to -4% 1 2% > -5% 11 17% Positive Returns Negative Returns 49% of portfolio monthly returns have been greater than 5% or less than -5% on a monthly basis

37 Measures of Risk Standard Deviation(σ) A measure of an investment s variability in performance This statistical measure is designed to first calculate the average return of investment product over a period of time and then to calculate the typical (standard) difference (deviation) from the average A measure of an investment product s historical return dispersion.

38 Measures of Risk Standard Deviation A plot of a normal distribution (bell curved). Each colour band has a width of one standard deviation Statistical theory tells us that any given outcome should fall within 1 std deviation of the mean about 67% of the time & within 2 std deviation about95%ofthetime.

39 Measures of Risk Sharpe Ratio A measure of the excess return (over the risk free rate) per unit of risk in an investment asset Usedtocharacterizehowwellareturnofanassetcompensatesthe investor for the risk taken. A Sharpe ratio of 1.07 means that for each 1% of risk taken on, the fund manager generated an excess returnof1.07%,overandabovetheriskfreerateofinterest. Information Ratio(IR) Measurestheamountofexpectedreturnperunitofrisk.Avalueof 1 is considered very good and indicates that value is added from active management. IRusedtogaugemanager sskill.

40 Measures of Risk Downside Deviation Downside deviation - the degree to which a manager's returns fall below the benchmark returns over the period measured. Tracking Error (TE) The deviation of a manager s return from the expected return, i.e. the difference between portfolio returns and benchmark returns. TE = Standard Deviation of Excess Return. Value at Risk (VAR) The maximum amount of money that one could lose with a given probability over a specific period of time the worst case scenario.

41 Case Study What to look out for

42 Case Study Illustration: Equity Mandate Guidelines Mandate Guidelines Return objective Benchmark FTSE/JSEShareholderWeighted Index (SWIX) plus 4% SWIX Tracking Error Less than 9%

43 Portfolio Analysis

44 Portfolio Analysis - Alpha

45 Portfolio Analysis Std Deviation

46 Portfolio Analysis- Impact of volatility

47 Portfolio Analysis - Downside

48 Portfolio Analysis - Deviation

49 Portfolio Analysis Tracking Error

50 Portfolio Analysis - Efficiency

51 Summary What Trustees should look out for: Strategy Performance target Risk budget Asset Managers Quality Performance& Risk Are we still on track? Are we within guidelines? Are we still comfortable? Are we happy? A full review may be necessary depending on responses to the above.

52 Conclusion Governance Ensure decision structure in place Clear assignment of responsibility& accountability Spend time understanding policy Manage member expectations. Efficiency Developariskplan Stick to decision framework. Flexibility Monitor proactively& regular review.

53 Thank you