Laun Middleton reveals the lessons pension funds can take from the Yale investment model to manage risk

The need to generate investment return implies a need to take risk – it is a necessary side effect of investing. The idea behind actively managing risk is simple – by skilfully exiting and entering markets, value may be added over the long term by locking in gains, avoiding losses and identifying market opportunities that other investors have not exploited or are unable to do so.

Investment managers employed by a fund will, in many cases, have a degree of flexibility in their mandate allowing them to implement their own views on whether taking risk is currently attractive or not. For a fund to have a dynamic asset allocation strategy, three processes need to be implemented:

1 Identify opportunities/risks.
2 Decide on strategy change.
3 Implement a strategy change.

The Yale Endowment Fund
The Yale Endowment Fund is set up to invest the donations received by Yale University. Like UK pension schemes it has a long investment horizon and can therefore have a diversified asset portfolio without a need for immediate liquidity. In 2010 the target asset allocation had only 16 per cent in listed equities, yet their estimate of their long-term expected growth rate was 6.2 per cent ahead of inflation.

The fund reviews asset allocation targets only once a year thus ‘limiting the possibility of damage from ill-considered moves made in response to the transient gloom or euphoria surrounding market movements’. However, Yale specifically recognises the opportunistic nature of absolute return strategies and seeks to vary allocations in response to changes in the investment environment. Furthermore, Yale will exploit compelling undervaluation in a country, sector, or strategy by allocating additional capital or even by hiring a new manager.

The key points of this approach are:
1 A high level of diversification with limited reliance on any single asset class or strategy.
2 An aversion to moving assets too frequently and thereby potentially destroying value.
3 A pragmatic approach that recognises the different characteristics of the various asset classes and strategies.
4 An appreciation that extreme under or over valuation can happen in markets and these present both risks and opportunities.

Obtaining diversification whilst maintaining high expected returns
This Yale asset allocation may surprise many pension funds, most of which have two big items in their asset and liability exposures – equities and real interest rates. The return of market volatility over the last few years has exposed the lack of diversity in many of these portfolios. The Yale example also suggests that expected returns can remain high while adding this diversification which is conceptually the simplest way for a fund to reduce risk.

However, not all funds will have the governance budget to investigate this approach and some may have a shorter investment horizon and so less appetite for illiquid investments. For such funds, one possibility would be to hedge risks by using options. Replacing physical equities with, for example, bonds plus equity call options has an interesting impact. Equity downside is now limited to the value of the option but upside is unlimited. Such a strategy is equivalent to a dynamic strategy where equities are sold in favour of bonds as the market falls, limiting downside risk, and purchased as the market rises preserving upside exposure. Funds that feel a need to remove equity risk but are concerned about losing out on an equity rally can remove their ‘regret risk’ with such strategies.

Casting the net wider
If you need to generate investment returns in your pension fund, you need to take risk. This is not a choice. Looking to other institutional investors can present a wider spectrum of ideas for consideration.

In practice the two key risk management tools of diversification and hedging should play a greater part in pension funds’ investment thinking. This should be supplemented by monitoring of markets to identify compelling opportunities. However, an ill-considered reactive approach to risk management is more likely to destroy value than preserve or enhance it.

Written by Laun Middleton, senior investment consultant, Towers Watson

Share Story: