(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.

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.