Ortec Finance Financial Risk Management for Pension Funds. Sacha van Hoogdalem Loranne van Lieshout Elske van de Burgt Martijn Vos Ton van Welie

Transcription

1 Ortec Finance Financial Risk Management for Pension Funds Sacha van Hoogdalem Loranne van Lieshout Elske van de Burgt Martijn Vos Ton van Welie

2 Contents 1 Introduction 2 2 Risk Management 3 3 Investment Process 4 4 Risk Management of the Investment Process 5 5 Ortec Finance solutions Ortec Finance methodology and models 9

3 1. Introduction This document is intended for everyone who is in some way involved with financial risk management for pension funds. In it, we describe the vision of Ortec Finance on this topic. Due to the financial crisis and the increased vigilance of the supervisor it has caused, financial risk management for pension funds is currently taking center stage. Calls for being in control or managing your future are omnipresent. When it comes to financial decision-making, Ortec Finance advocates an integral and consistent approach and this belief pertains to risk management as well. In this document we demonstrate how by using a cascade model across and between the various layers of the investment process, risk management can be consistently organized. We will start at the strategic level and expressly and explicitly include all relevant details of daily asset management. And, vice versa, the risk management at the implementation level is organized in such a way that it is possible to connect consistently with all other levels of the investment process. The unique combination of the cascade model and our Dynamic Scenario Generator (DSG) enables one to set up financial risk management for a pension fund consistently: on every desired horizon, with each relevant frequency, and for every level of the investment process. The document will first give a brief introduction to risk management. Then it will discuss the investment process for pension funds. Subsequently, we will describe how one should give form and substance to the risk management of every phase in this investment process. Finally, we explain, solidly grounded in our vision on risk management, the methodology Ortec Finance applies to its models. 2

4 2. Risk Management Ideally, every financial decision consists of the careful establishing of a strategy with an explicit risk-return trade-off, making sure the implementation is in line with this strategy (Goals and Risk Attitude), and a process of monitoring both strategy and implementation. Risk management is defined as recognizing which risks are relevant in this process (Identifying Relevant Risks), and taking control measures (Risk Control Measures) in case expected or unexpected ( Black Swans ) risks will occur (Risk Monitoring Feedback and Adjustment). To institutional investors, and therefore also to pension funds, it is extremely important that risk management not only focuses on the risks to avoid (the nonrewarded risks), but also on risks that are deliberately taken in order to realize the goals of the end clients (the rewarded risks). 1 Risk management seeks to achieve the original goals an organization has in fact set for itself. Risk management as described in this document is exclusively limited to the investment process. As with each type of risk management, financial risk management happens organization-wide. This means that it should form an important part of the culture of an organization. An open and proactive attitude regarding risks at each level of the organization contributes to the early recognition of risks and taking the desired control measures, if so needed. 1 See, for similar positions, Enterprise Risk Management (ERM) by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and the report Integraal Risicomanagement by the Pensioenfederatie. 3

5 3. Investment Process The strategic goals an organization has form the starting point of the investment process. In case of a pension fund, for example, it involves: investing the contributions now in order to pay out index-linked benefits in the future paying pension benefits indexing pension benefits The board of a pension fund is given the task to develop a policy framework in order to realize the strategic goals. In doing so the board is confronted with all kinds of risks. Some of these risks are expected to yield return, while other risks do not produce anything of value. An example of a risk that is expected to be rewarded is market risk. Pension fund boards deliberately take market risk, with the intent to achieve positive return. An example of a risk that is not expected to be rewarded is concentration risk. After all, a good distribution of the portfolio across various countries, sectors or issuers ensures that the fund is less sensitive to a particular risk and that there is little reason for the market to pay a premium to investors running this risk. In determining the policy framework the pension fund board will set its risk-return attitude. A major role is played here by the balancing of contribution, ambition and risk. The board makes choices regarding the contribution, indexation and investment policy. In doing so, it should map which risks are relevant, and determine what position must be taken regarding risks that are rewarded. In setting a so-called maximum exposure for these risks, the board makes a deliberate choice on how risk is channeled to the stakeholders. In this phase of the investment process the board determines the strategic portfolio. This strategic portfolio is subsequently translated into a real portfolio. In the real portfolio a number of steps are taken, each leading to a consecutive decision regarding the implementation and/or refinement of the investment portfolio, following the restrictions and starting points of the previous step. The figure to the left shows an example of such an investment process. 4

6 4. Risk Management of the Investment Process In setting up the investment organization it is important that there are sufficient control measures to guarantee that the intended risks are actually taken, and that the other (unrewarded) risks are controlled in the best possible manner. In defining these control measures there should always occur a chance-impact analysis and a cost estimate, in order to judge whether it is worth the effort to take an individual control measure or not. A key part of these control measures is that when translating the strategic goals into an actual investment portfolio, corresponding limits are formulated. Establishing control measures and limits within the organization should be a consistent whole. In other words, one must always look to what extent all measures fit properly with each other and to what degree they contribute to the original goals of the pension fund. Risk management makes sure that all risks are correctly identified and labeled, that suitable control measures are determined and that high-quality monitoring and adjustments occur. At each level of the investment process choices are made to further implement the investment portfolio, and in addition restrictions or mandates are passed on to the next level. As can be deduced from the figure below ( Investment Process & Risk Management ) risk management should connect with this layered structure. At each level risk management of the decisions taken should occur, plus a verification that the prescribed limits have been adequately obeyed at this and deeper levels. Such limits are shaped in restrictions or mandates. The risk management models must correspond with this specific layered structure of the investment process. 5

7 Two examples may help explain this figure. At the highest or top level the risk-return trade-off is made. This results in a pension deal and a strategic mix. Subsequently conditions are set for the portfolio construction to make sure that the implementation is in line with the (aforementioned) strategy. Moreover, in this phase it can also be determined how adjustments will be made based on changes in the coverage ratio or in the volatility of the coverage ratio. At the bottom level, on the other hand, each asset manager will receive an individual investment mandate. A solid investment mandate contains at least the following components: A clearly-defined investment strategy, including the permitted investment universe. This is often formed by a well-picked benchmark that fits with the intended risk profile of the mandate; Clear and easy-to-measure tracking error limits (or other risk limits); Other limits, for example in terms of minimal and maximal exposures maximal deviations of hedges concentration limits country limits credit limits In order to guarantee the asset manager sticks to the mandate, the asset management organization should also have a good risk management process. This risk management process secures, among other things, that the manager obeys the predetermined limits, ex-ante risk limits (such as tracking error limits) are not exceeded, and that reliable ex-post systems exist to measure and explain the achieved returns. The asset management organization should furthermore possess an independent risk management function and clear internal and external escalation procedures. The asset manager must periodically provide his client the layer above in the decision process with relevant information that shows agreements are being kept. The role of the client is to check whether the asset manager indeed honours the agreements and whether he or she is supported by robust and reliable processes and systems. To do so, the client can periodically perform an audit and set demands regarding the certification of the processes of the asset manager. The client consolidates the information provided by the asset manager and thoroughly reviews this. This assessment has as objective to verify whether the set limits and agreements have been met and whether additional control measures are needed. In addition, the client should monitor whether the decisions he makes meet the limits that were handed to him. And, for example, make sure that after the manager selection (the ex-ante risk of) the sum of all individual mandates satisfies the limits stemming from the portfolio construction phase. 6

8 5. Ortec Finance solutions The Ortec Finance solutions regarding financial risk management for pension funds focus on all stages of the investment process, with the exception of the asset management stage. The solutions have as principal task to support the management of financial risks at board level. Risk management at the bottom level of the investment process is usually left to the asset manager within a clear mandate. The board, understandably, retains the direction regarding these risks and the overall end responsibility. In its role as director the board makes agreements with the contractors (among which the asset managers) about which activities will be outsourced, how risk management will happen, and what exchange of information exists between the board and the contracted parties. Financial risk management for pension funds as offered by Ortec Finance, consists of the following elements: 1. Overview of the current coverage ratios and asset value, as well as an explanation for their development over the recent period. 2. Check on assumptions: are the realized risks and returns still in line with the original assumptions that were made when the strategy was determined? 3. Check if the long and short-term strategic goals are still feasible and the accompanying risks are still acceptable (i.e. not merely return and risk measures of the coverage ratio, but also the expectations and risks regarding indexations, discounts and premiums). 4. Monitoring status of important risk factors: a. strategic risks such as equity risk, interest rate risk, currency risk and credit risk b. operational risks such as liquidity risk, concentration risk (for example countries, issuers, currency and sectors) and counterparty risk 7

9 To help consolidate and review the underlying processes the following information is needed: 1. Insight in the effectiveness of the control measures: a) compliance reports b) report by the risk manager about exceeding limits and subsequent actions taken 2. Performance reports The above-mentioned elements typically take place on a monthly basis. But good risk management also provides snapshots and see-throughs of the portfolio, based on the most recent developments in the (financial) world. Related to this it is also possible to perform stress tests on the actual portfolio at any preferred moment, usually in response to recent market developments. 8

10 5.1 Ortec Finance methodology and models Ortec Finance provides models and services to support the financial risk management for pension funds as described in the previous pages. The Ortec Finance simulation model is applied to the ex-ante analyses, while our performance evaluation model is being used for the ex-post analysis. Both systems use the real underlying, individual positions at the present moment as a starting point. The ex-post model records the current situation and subsequently reports on this. The pension fund has access to a daily update of the status of the investment portfolio. This allows for regular, as well as instant see-throughs of the portfolio. This way one can quickly adapt to the latest market developments 2. The core of the ex-post model is doing the performance evaluation analysis. The realized return can be explained based on decisions as well as the contribution of the various investment categories and/or mandates. Because the model is fed daily by the actual benchmark and portfolio data, it is also an information source on the development of the market situation. Think here of the information about current market volatilities. This real information can be compared with the assumptions used in the ex-ante simulation systems. Long-term or large deviations between the original assumptions and the actual realties observed can serve as a signal to reconsider the economic assumptions and potentially adjust the strategic policy. Finally, a large number of standard checks and controls can be added to the system, thus daily rendering an actual overview whether the pre-determined limits are violated or not. For monitoring the ex-ante simulation model is used. At the highest level of the investment process calculations are made in order to give the actual situation of the coverage ratio and the economic climate, gain insight to what extent long and short-term goals and risks are still feasible and acceptable. At the lower levels of the investment process it looks whether the ex-ante risks of the actual portfolio (up and to the management level) are in line with the ex-ante risks of the strategic portfolio. Risk here is primarily viewed in terms of coverage rate risk 3. Other risk types are possible here as well. The ex-ante risk models of Ortec Finance are unique in drawing on years of research to ensure that the characteristics of the scenarios per risk driver contain the desired features on different time horizons 4. Important elements in this are: term structure of risk and return: risk and return characteristics such as mean, volatility and correlations vary over time; business cycle behaviour short-term behaviour such as: tail risk: correlations increase in the tails non-normal distributions stochastic volatility 2 Pension funds can opt for a daily data feed, but it is also possible to choose for a monthly or two-weekly data feed 3 Coverage ratio risk is defined as standard deviation or CVar of the coverage ratio growth or coverage ratio return; also known as geometric tracking error regarding the liability benchmark 4 Think here of monthly, yearly or multi-year frequency 9

11 The scenarios that are generated by the Ortec Finance model contain these desired characteristics for both the short as well as the long term. In monitoring the strategy we look at both the short and the long-term developments. With long term we mean a period of three years or longer, with short term merely one month. In monitoring the intermediate period we usually look at a period of one year. The actual portfolio is modeled by starting at the individual positions in the portfolio, and aggregating them to several hundred risk categories. In addition, the strategic portfolio is modeled by modeling, for each manager, the investment strategy included in the mandate. This is done by using the benchmark that accompanies the mandate. If this benchmark is no accurate reflection of the risks in the portfolio 5, a customized benchmark can be used. In such cases we will compile an alternative benchmark describing the risks of the underlying portfolio in the best possible manner. Think, for example, of specific country assessments within a Euro government bond portfolio. Furthermore, a budget can be modeled for the implementation risk. We have chosen to model on (customized) benchmark level, and not based on individual titles, because the analysis will also look at the intermediate and long term. For such periods it is not realistic to maintain the actual positions, and is the risk of the strategic or tactical portfolio especially relevant. In a number of situations, however, individual parts will have a significant impact on the total risk of the pension fund. In such cases we make an exception and do model individual parts in our model. Examples of this are the use of (nonlinear) derivatives or highly-concentrated portfolios, such as large positions in government bonds of specific countries. 5 An example of a non-suitable benchmark is an absolute return benchmark. This is applied in certain hedge fund styles in which the benchmark, for example, is selected as a short interest rate plus x%. 10

12 In summary, we characterize our methodology and our corresponding solutions for the risk management of pension funds as follows: risk management on the first three levels (monitoring the strategy, the portfolio construction and the manager selection) must be based on aggregated data. Risk management on the fourth level, on the other hand, must be performed on a daily basis and based on raw, non-aggregated data. The latter is primarily the responsibility of the (mostly external) asset managers. The pension board must consolidate and evaluate the risk management of the asset manager(s), but not redo their work. Naturally, the aggregated data in our methodology must be consistent with the individual raw data. This is achieved by the mapping of the (thousands of) individual positions into several hundred aggregated levels, which serve as input for the simulation in the ALS for Pensions system. Special products, like derivatives, will be exactly modeled. Consistency is achieved by an adequate modeling of the benchmark portfolios provided to the portfolio managers (if applicable, including a risk budget for the manager). This transformation is fully automated by our ex-post system PEARL, which is loaded with data from the custodian. This automatically guarantees that there is a consistent ex-post and ex-ante setup. This is unique in the industry. In order to follow this methodology correctly our ALS for Pensions system has been expanded in two dimensions. First of all, it can now model hundreds of asset categories, something hardly necessary for ALM, but crucial for ex-ante risk measures. Secondly, ALS for Pensions can now generate monthly scenarios, which is unnecessary in support of strategic decisions, but crucial for risk management goals. Finally, our ex-post system PEARL can be used to calculate ex-post risk figures and for performance and attribution calculations. This system works with the actual portfolio on a daily basis. Because the PEARL system uses daily, nonaggregated data, it offers the opportunity to make see-throughs and drill downs. For clients and prospects who want to look at ex-ante risks on individual positions, we can if so desired offer a combined solution with an external party. 11

13 Ortec Finance bv Boompjes XB Rotterdam The Netherlands Tel. +31 (0) Fax +31 (0) Ortec Finance bv Barajasweg CP Amsterdam The Netherlands Tel. +31 (0) Fax +31 (0) Ortec Finance Ltd 23 Austin Friars London EC2N 2QP United Kingdom Tel. +44 (0) Fax +44 (0) Ortec Finance AG Poststrasse Pfäffikon SZ Switzerland Tel. +41 (0) Fax +41 (0)