Are Asset Drawdowns the Biggest Threats to CIOs, Fund Managers?

Investors are focused on the wrong objective, trying to keep up with indexes as opposed to trying to minimize volatility by limiting drawdowns, asset owners and managers say.

(May 17, 2012) — Portfolio drawdowns are the premier risks for the institutional investing industry — risks that are often overshadowed by an obsession with volatility, chief investment officers and asset managers say.

The cost of underfunding is often an overshadowed concern, as one CIO, Sam Kunz of the Chicago Policeman’s Annuity and Benefit Plan, says. That is, the effects of underfunding are magnified as negative cash flows — all too familiar among pension funds worldwide — become increasingly significant as funding ratios deteriorate.

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Others note that forcing managers to follow an index is wrong and misleading. Instead, the real key is losing less due to the effects of compounding. “Low drawdown investment is more important than low-volatility investing,” says Michael Dieschbourg of Broadmark Asset Management. “If you have drawdowns, you don’t have as much to compound with. If you lose money, you need to make more back before you can start compounding. Time becomes an issue.”

Our predecessors such as Ben Franklin and Albert Einstein may have agreed. Franklin called compound interest the “eighth wonder in the world.” When asked, “What is the greatest mathematical discovery of all time?” Albert Einstein replied: “Compound interest.”

For Paul Joss, an Investment Strategist at Hartford Investment Management Company, the focus is on managing asset versus liability dynamics for corporate pension plans. “We’re focusing increasingly on asset performance versus the liabilities they support as opposed to focusing purely on performance relative to an ‘asset-only’ performance benchmark.”

He adds: “Drawdown risk versus liabilities is therefore extremely important.”

In other words, according to Joss, while managing funded-status volatility should be the aim among asset owners and managers, attention to downside risk is often not given enough weight in terms of its impact on investment success over the long-term. While industry sources note that it is important to manage assets versus liabilities, the institutional investing community often relies on “asset-only” indexes and benchmarks to measure and define investment manager success, when ultimately that may not be the best objective. “Investment managers feel a lot of pressure to manage versus the index that is specified for them,” Joss stated.

The solution? Give clear, explicit direction as to what the performance objective actually is, says Joss. “It’s often not specified clearly enough.”

Broadmark’s Dieschbourg says that institutional investors should minimize volatility of contributions and funding status by losing less in order to compound more effectively, noting that the math of compounding is overlooked especially among defined benefit pension plans and with foundations and endowments. “If you have an 8% hurdle, you have 8% that’s compounding every year — the power of compounding is being lost in trying to make things simple in modern portfolio theory,” Dieschbourg continues.

The take-home point: Losing often hurts more than gaining when it comes to returns.

(May 17, 2012) — A Japanese pension fund has become the first in the country to allocate to gold, albeit through an exchange-traded fund, in an effort to escape being hit by world economic troubles.

The Okayama Metal & Machinery pension fund has allocated 1.5% of its Y40 billion ($500 million) to a physically-backed ETF, the Financial Times initially reported.

Yoshisuke Kiguchi, Chief Investment Officer at the fund, said the move was to ‘escape sovereign risk’.

Japanese pension funds have traditionally invested in high-quality fixed-income, with a lesser allocation to other mainstream assets. According to Towers Watson’s asset allocation survey, published this year, some 59% of all assets in Japanese pension funds were fixed-income securities. This is the highest percentage of allocation to this asset class by any nation with a major retirement fund sector.

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Japanese pension funds, on average, hold 80% domestic securities in their bond portfolios, according to Towers Watson. The average yield on a 10-year Japanese government-backed bond is around 1%.

Over the last 10 years, Japan has been the only country with a large pensions industry to see an aggregate drop in the level of its assets in local currency terms – despite the majority of funds being open defined benefit schemes. Assets fell by 0.7% over the 10 years to the end of 2011, Towers Watson said, mainly due to the poor domestic capital markets.

Although gold is a non-yielding asset, its safe-haven status has been desired by some during continued economic crosswinds.

Kiguchi said the pension fund trustees had been convinced of this investment decision as over the long term gold could result in being one of the ‘safe currencies’, the Financial Times reported.

Last week, gold hit $1600 an ounce as the Eurozone crisis continued to deepen, yet fell back shortly afterwards, despite no clear fiscal resolution in the region. This has led to some querying its safe haven status.