Asset-Liability Management - July 18, 2012

The more sophisticated the approach, the higher the potential benefits - an interview with Pierre Moulin

In this month's interview, we talk to Pierre Moulin, Head of Financial Engineering at BNP Paribas Investment Partners, about the latest study from the BNP Paribas Investment Partners research chair on asset-liability management (ALM) and institutional investment management, the lessons for the investment management industry in the aftermath of the financial crisis, and the partnership between BNP Paribas Investment Partners and EDHEC-Risk Institute.

Pierre Moulin

EDHEC-Risk Institute has released a new study from the BNP Paribas Investment Partners research chair on Asset Liability Management (ALM) and institutional investment management, entitled “Dynamic Investment Strategies for Corporate Pension Funds in the Presence of Sponsor Risk.” What are the key lessons to be drawn from this research in your opinion?

Pierre Moulin: This new survey is the latest from EDHEC-Risk Institute and BNP Paribas Investment Partners, celebrating our fifth year of cooperation. We are once again proud of the fruitful work carried out through the research chair, which, as always, explores new lines of thinking.

This new study re-affirms the benefits of dynamic risk management for pension funds, capitalising on what was learned from the two previous studies and going a step further. Several types of dynamic risk management strategies are analysed in an integrated ALM framework (as introduced in the previous paper, taking into account the pension funds’ different stakeholders: shareholders, pensioners, bond holders), and their respective benefits are measured. Interestingly, the paper shows that the more sophisticated the approach, the higher the potential benefits. The paper also extensively discusses practical considerations related to the incompleteness of markets and the consequences for investors. The good news is that the results of the study hold good even in a less theoretical framework.

BNP Paribas Investment Partners strongly believes in dynamically managing risk for institutional clients. Its rationale for this is that each solution should be designed specifically for each client, taking into account his specific situation and objectives, in order to strive for the optimum benefits. This adaptation of solutions also effectively mitigates the criticisms sometimes made of risk management in relation to its potential pro-cyclical behaviour. The more fine-tuned the solution, the lower the risk from having everyone doing the same things at the same time.

The paper shows that imposing a cap on the funding ratio, in addition to a floor, has a positive impact for both pensioners and bondholders, while only having a minor negative effect on equity value. Do you think that this result might be considered counter-intuitive by some of your institutional investor clients?

Pierre Moulin: On the contrary, I believe this result may well confirm many institutional investors’ intuitions. Given the drastic decline in funding or solvency situations these last years, institutional investors are quite receptive to the idea of “locking in” profits: if funding ratios come back to more comfortable levels in the coming years, they are likely to be happy to secure the funding ratio by reducing risky assets.

This type of approach, imposing a cap in addition to a floor on the funding ratio in active risk management, is actually one that we have been discussing and implementing for institutional clients for some years. It is also an interesting approach to help clients who find themselves “under water” define their “recovery” strategy.

More generally, I think institutional investors are quite receptive to products or solutions bringing asymmetry, e.g. ceding some upside to protect against downside risk. This is true not only for risk management solutions, but also in building strategic allocations or choosing portfolio constructions that offer defensive properties. We need to help pension funds reduce the uncertainty for their stakeholders: managing distribution tails (on both the positive and negative sides) of funding ratio distribution is a big part of the answer.

The paper also introduces novel forms of dynamic strategies that recognise that pension risk is not only driven by the funding ratio of the pension fund, but also by the financial strength or weakness of the sponsor company. Is this a difficult subject to discuss with institutional investors?

Pierre Moulin: Our approach is to partner with institutional investors. Their issues are our issues, and we want to be involved in finding solutions to these issues. It is hard enough for institutional investors to be facing the difficulties: hopefully discussing them doesn’t add additional difficulties but rather ideas for improving the situation.

For a sponsor company, making an additional contribution is never good news, but what is really a big problem is to have to contribute when the company itself is in bad shape. Given that any form of protection has an embedded cost, saying that this cost can be reduced by avoiding unnecessary protection is something quite straightforward to explain to a client. What is trickier is to discuss how this can actually be achieved. The paper is a good step in this direction and it is our duty to make it practical and easy for our clients to understand.

We spoke previously about the importance of risk management in the aftermath of the financial crisis. Are there any further lessons that the investment management industry might have learnt over the past three years?

Pierre Moulin: I’m sure the investment management industry has learnt a lot. In periods of strong turbulence, there is no other choice but to accelerate adaptation if you want to remain a reference investment manager.

At BNP Paribas Investment Partners, there have been many areas of development linked to equity market behaviour conditional to risk criteria, low rate environment, evidence of default risk on European government bonds, etc. If we just focus on risk management, we have spent the last three years on including risk management at different combinable layers of an investor’s portfolio.

The first layer consists of dynamic risk management between the LHP and the PSP. Based on its sound experience and expertise in this area, BNPP IP’s LDI & FM team considers either funded or unfunded risk management (i.e. risk overlays). A risk overlay approach offers great flexibility in terms of both set-up and investment strategy. As to set-up, it enables risk to be managed dynamically on an overall portfolio level without interfering with the management of the underlying assets, thanks to the use of derivatives and to comprehensive data sourcing. In terms of investment strategy, a wide spectrum of possibilities is available to build a fully customised solution corresponding both to an objective and to triggers that are determined via a close partnership between the risk manager and the institutional client.

The second layer consists of the construction of the PSP risky portfolio itself, including the possibility of introducing embedded protection features. One way is to incorporate assets with an asymmetrical behaviour in the strategic allocation, for example long volatility or a systematic sell of calls. Another way, for a given asset class, is to opt for a portfolio construction resulting in a defensive behaviour. One example is low vol equities, on which we have published extensive research and which tend to offer an enhanced risk/return ratio while limiting volatility and drawdowns.

In the end, the best fit solution(s) to actively manage risk will depend on an institutional investor’s specific situation, objectives and constraints.

BNP Paribas Investment Partners is a long-standing partner of EDHEC-Risk Institute’s research. What motivates you to support the research produced by EDHEC-Risk?

Pierre Moulin: Indeed, EDHEC-Risk Institute and BNP Paribas Investment Partners have now been cooperating for five years. In that time, three papers have been published and the Institute for Quantitative Investment Research Europe (Inquire) gave Lionel Martellini an award for a presentation he made that was based on the Chair’s research.

If we come back to the genesis of the partnership, our reasoning was that ALM is a key area for institutional investors, and that being involved in research on the subject could help us continue to provide cutting edge solutions to our clients in this area. This target has been met: our regular exchanges with Lionel Martellini have definitely fed us with questions and ideas that have helped us to constantly improve our risk management approaches. Of course, there is a big step between academic research and concrete investment solutions for institutional clients. But it is precisely our job within the Financial Engineering Team to extract the essence of conclusions drawn in research to design tailor-made solutions for pension funds, corporate clients and insurers – hand in hand with our Liability-Driven Investments team with its solid experience and expertise in risk management.

We are also very excited by the next topic, which will be the ultimate synthesis of our cooperation: How to mix the apparently conflicting objectives of, on the one hand, managing risk and, on the other, benefiting from risk premium long-term mean-reverting behaviour?

About Pierre Moulin

Pierre Moulin joined BNP Paribas asset management business in 2006 to create its financial engineering expertise. This team, comprising over 30 professionals based in Paris, London, Amsterdam, Boston and Hong Kong, is positioned transversally to BNPP IP’s investment teams. It brings together highly-skilled quantitative investment professionals, all graduates of leading engineering and scientific universities.

Pierre joined BNP Paribas in 1997, as an option trader in the equity derivatives business of BNP Paribas’ CIB division in Frankfurt before becoming his desk head. In 2002, he joined the “General Inspection” division of BNP Paribas, and became Head of Mission in charge of strategic assignments.

In 1997, Pierre graduated from the Ecole Centrale de Lyon, and as a specialist in Financial Engineering from the Ecole Centrale de Paris.

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