Leverage in Pension Fund Investments

Transcription

1 Leverage in Pension Fund Investments ICPM Discussion Forum Mike Simutin Rotman School of Management June 12, 2018

2 Modern Portfolio Theory and Leverage Expected Return in Percent, E[R] R F 2 Capital Allocation Line (CAL) M Efficient Frontier Risky Assets Standard Deviation in Percent, σ

3 Modern Portfolio Theory and Leverage Expected Return in Percent, E[R] R F 2 Capital Allocation Line (CAL) M Efficient Frontier Risky Assets Standard Deviation in Percent, σ

4 Modern Portfolio Theory and Leverage Expected Return in Percent, E[R] 14 Capital Allocation Line (CAL) 12 Target return R F 2 M Efficient Frontier Risky Assets Standard Deviation in Percent, σ

5 Modern Portfolio Theory and Leverage Expected Return in Percent, E[R] Capital Allocation Line (CAL) Target return R F 2 Efficient Frontier Without leverage M Risky Assets Standard Deviation in Percent, σ

6 Modern Portfolio Theory and Leverage Expected Return in Percent, E[R] Capital Allocation Line (CAL) Target return R F 2 With leverage Efficient Frontier Without leverage M Risky Assets Standard Deviation in Percent, σ

7 Balance Sheet Leverage of Pension Funds Has Been Increasing All of the leverage survey responders indicated that their leverage either increased or stayed the same over the last five years None of the responders tightened leverage limits over that time

8 Why Has Leverage Been Increasing? Ultimately boils down to beating the benchmarks Return-seeking behaviour Return enhancement Expanded opportunity set With low interest rates and a real return target of about 4%, beating benchmarks without relying on leverage is difficult

9 Attention by Media/Industry

10 Attention by Policy-Makers the trends toward more illiquid assets, combined with the greater use of short-term leverage through repo and derivatives markets may, if not properly managed, lead to a future vulnerability that could be tested during periods of financial market stress Bank of Canada, Financial Systems Review, June 2016 In Canada, pension funds Hold 15% of assets of the financial system, and Serve as counterparty to 15-35% of the total amount of repos reported on balance sheets of financial institutions

11 Pros and Cons of Leverage

12 Is Leverage Too High? Some survey responses indicated strict limits on leverage usage Academic literature on pension funds use of leverage is virtually absent We can still learn a lot by looking at leverage use by other asset managers

13 To Constrain or Not To Constrain? Almazan, Brown, Carlson, and Chapman (2004) study leverage and other investment constraints in mutual funds Leverage restrictions are more common when Boards contain a higher proportion of inside directors The fund is managed by a team rather than an individual The fund does not belong to a large organizational complex On a risk-adjusted basis, constrained and unconstrained funds perform similarly

14 Reaching for Yield Sophisticated constrained investors reach for yield in an effort to beat benchmarks

15 Reaching for Yield Sophisticated constrained investors reach for yield in an effort to beat benchmarks Becker and Ivashina (2015) show that conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds

16 Reaching for Yield Sophisticated constrained investors reach for yield in an effort to beat benchmarks Becker and Ivashina (2015) show that conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds Hanson and Stein (2015) show evidence of reaching for yield among commercial banks Di Maggio and Kacperczyk (2017) document a similar effect even among the much tighter regulated money market funds

17 Reaching for Yield Sophisticated constrained investors reach for yield in an effort to beat benchmarks Becker and Ivashina (2015) show that conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds Hanson and Stein (2015) show evidence of reaching for yield among commercial banks Di Maggio and Kacperczyk (2017) document a similar effect even among the much tighter regulated money market funds Choi and Kronlund (2017) show that corporate bond mutual funds engage is similar behaviour

18 Reaching for Yield Sophisticated constrained investors reach for yield in an effort to beat benchmarks Becker and Ivashina (2015) show that conditional on credit ratings, insurance portfolios are systematically biased toward higher yield, higher CDS bonds Hanson and Stein (2015) show evidence of reaching for yield among commercial banks Di Maggio and Kacperczyk (2017) document a similar effect even among the much tighter regulated money market funds Choi and Kronlund (2017) show that corporate bond mutual funds engage is similar behaviour Christoffersen and Simutin (2017) show that equity mutual funds facing greater benchmarking pressures tilt their portfolios to riskier stocks

19 Reaching for Yield Bulging BBBs The percentage of investment-grade bonds rated BBB has reached record highs during the last 12 months, with a particularly sharp rise in Europe in recent years... 50% U.S Global Eurozone...while the difference in corporate yields has tightened considerably, especially recently. 10% Global corporate bond indexes* BBB *Bank of America Merrill Lynch global corporate bond indexes Sources: International Monetary Fund (investment-grade bonds); FactSet (yields) 2 AAA THE WALL STREET JOURNAL.

20 Reaching for Yield Bulging BBBs The percentage of investment-grade bonds rated BBB has reached record highs during the last 12 months, with a particularly sharp rise in Europe in recent years... 50% U.S Global Eurozone...while the difference in corporate yields has tightened considerably, especially recently. 10% Global corporate bond indexes* BBB *Bank of America Merrill Lynch global corporate bond indexes Sources: International Monetary Fund (investment-grade bonds); FactSet (yields) 2 AAA THE WALL STREET JOURNAL. Regulators and academics have expressed opinions that reaching for yield has been one of the core factors contributing to the buildup of credit that preceded the recent financial crisis (Rajan 2010, Yellen 2016, Feroli, Kashyap, Schoenholtz, and Shin 2014)

21 Leverage Constraints: Implications for Asset Pricing Reaching for yield appears to lead to relative over-pricing of riskier (higher-yielding) securities Unconstrained investors like pension funds are in a particularly good position to take advantage of this

22 Leverage Constraints: Implications for Asset Pricing (FP, 2014)

23 Leverage Constraints: Implications for Performance Measurement Some survey responders indicated that benchmarks used do not directly incorporate leverage

24 Leverage Constraints: Implications for Performance Measurement Some survey responders indicated that benchmarks used do not directly incorporate leverage Leverage can introduce non-linearities in payoffs Linear models are inappropriate in such cases (Jagannathan and Korajczyk, 1986) and may lead to biased performance measurement (Boguth, Carlson, Fisher, and Simutin, 2011)

25 Leverage Constraints: Implications for Performance Measurement Some survey responders indicated that benchmarks used do not directly incorporate leverage Leverage can introduce non-linearities in payoffs Linear models are inappropriate in such cases (Jagannathan and Korajczyk, 1986) and may lead to biased performance measurement (Boguth, Carlson, Fisher, and Simutin, 2011) Standard performance evaluation models may also give biased results if leverage dynamically changes (e.g., with market volatility)

26 Conclusion Used appropriately, leverage offers the promise of improved risk-return tradeoff Effective management/oversight/stress-testing is crucial Academic evidence suggests that leverage-constrained investors may form sub-optimal portfolios as they chase a benchmark Performance measurement should carefully account for leverage

27 Thank You