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Responding To The Tough Times

By: Bob Collie

Not only are good returns hard to find, risk seems more real than ever today. This new situation has imposed a new discipline and investors are paying attention to things that had been below the radar before. Bob Collie, of Frank Russell Securities, Inc., examines cash equitization as a risk management technique.

The Cascade mountain range, stretching from Northern California to British Columbia, is a dominant feature of the North American west coast. To those living west of that range, rain is not precious. Vancouver, Seattle, Tacoma, and Portland, let’s face it, a little less rain around here would not be a big problem. When I first moved to this area, I asked one of the locals if it always rained here. “How should I know,” he replied, “I’m only six”

Cross over the Cascades and it’s a different story. This is where you find yourself in the rain shadow. Every drop is precious. This is where vines flourish. This is where the Columbia River has been dammed and harnessed to bring water to needy land.

Investing from 1974 to 1999 was like living in Seattle or Vancouver. That rain just kept on falling. Double-digit returns were commonplace. Did markets always go up? There was no point asking anybody under the age of six that question, or anybody under the age of 25 for that matter. But early in 2000, we crossed into the ‘return shadow.’ Gains no longer fell from the skies; they evaporated before our eyes. Every basis point became precious.

This new situation has imposed a new discipline. Investors are paying attention to things that had been below the radar before. But not only are good returns hard to find, risk seems more real than ever. As Paul Owens, plan manager and CEO at the $3.4 billion College of Applied Arts and Technology (CAAT) Pension Plan in Ontario, puts it: “Markets are more volatile and the impact of that volatility is greater than I’ve ever known.”

This is a view shared by many and it’s a view based in reality. Chart 1 shows the impact on the typical pension plan of allowing asset allocation to drift. It assumes that at the start of each month, the actual position of the plan depends solely on how markets moved in the previous six months. If equities were the best performing class over that period, then equities were overweight. If bonds performed best, then they were overweight, and so on. The chart then shows the effect that this overweight/ underweight position has: if the overweight class performed well over the month in question, then there is a positive impact, if poorly then negative.

Impact No Longer Relatively Small

For the first five years of this analysis, the impact was relatively small, never much more than 10 basis points (0.1 per cent). This was not an environment in which most plans got worried about asset allocation drift.

More recently, the picture has been less benign. The impact, in a single month, has frequently been more than 20 basis points (0.2 per cent). Sometimes the impact has helped returns, but often it has hurt. Sixty basis points (0.6 per cent) is a lot of return to lose in a single month from a risk that was never intentionally taken in the first place. However, that is what happened to some plans last October.

These large numbers come up again if we extend the analysis further back in time. History implies that maybe it is 1993-1997 that was the unusual period, not 1998-2002.

Now, any given plan will have a different experience from that shown above, but the pattern is probably very similar. What for years was a small effect has become bigger and bigger. As a way to deal with this volatility, plan sponsors are paying more attention to rebalancing back to the plan’s policy asset mix.

Let’s look at how investors are responding to this new, tougher environment. At CAAT, Owens says, “We’re taking rebalancing much more seriously. We now have a program in place to look at the position every single day. Every contribution is allocated to an underweight area, withdrawals are taken from the overweight ones. There is a huge efficiency gain by treating cash equitization and rebalancing as one task, not two.” Cash equitization is a technique which is proving more popular in the new environment, where the details are given more attention. And cash is quite a detail. Plans which have no strategic allocation to cash commonly carry as much as three or four per cent in cash once everything is taken into account.

Cash is found in the plan’s own bank accounts – it’s impossible to operate without some sort of liquidity buffer – and substantial holdings can also be found in the portfolios of most active equity managers. The recent Russell Viewpoint, ‘Mind the Gap – Effective Policy Implementation,’ puts the historical impact of these holdings at an average of 15 to 17 basis points (0.15 per cent to 0.17 per cent) a year in performance slippage That sort of return drag is not something that should be overlooked.

CAAT and others deal with this by taking advantage of the ever-more-liquid futures markets. Owens says “Our board would not accept a proposal that suggested using futures or other derivatives to speculate. But they are very comfortable with the program we have in place to plug the cash gap and reduce the cost of rebalancing. We’ve got clear guidelines in place and that means no leverage.”

Futures Are Ideal

Futures are ideal for dealing with cash holdings because they can provide exposure to the markets without disturbing the operation of the plan or the money managers. This is because futures achieve market exposure on margin, with an outlay of just a fraction of what buying the underlying stocks would require. This feature is what makes synthetic instruments so risky when they are used to speculate. Your losses can be much more than your initial investment. But when used only to get market exposure for assets the plan owns, that same feature becomes a means of risk reduction, not leverage. The fact that they cost a fraction as much to trade as physical securities is good news, too.

We see at CAAT and others today a more disciplined approach to dealing with cash holdings and asset allocation drift. Actions are taken much more swiftly and the prudent use of futures results in considerable cost savings. These habits are best practiced in good times and bad. We expect these disciplines to become tomorrow’s standard for the prudent administration of large pools of capital.

Bob Collie is a director at Frank Russell Securities, Inc. in Tacoma, Wash.

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