Reconciling institutional investors’ short- and long-term perspectives

Due to the prudential and accounting regulations that insurers and pension funds are subject to, the short term cannot be ignored. This is their dilemma: how to ensure short-term protection and, at the same time, benefit from a distant investment horizon. The use of traditional asset/liability management (ALM) techniques to protect capital over the short term ultimately boils down to under-investing in risky assets, especially as, since the crisis, the ability of diversification to ward off the risk of extreme losses has, for good reason, been called into question. If investors cannot manage to reconcile the short and long terms, they will have no choice but to settle for low returns on their assets or to accept the ups and downs of the markets.

Risk management and asset allocation approach

Short-term constraints and long-term performance potential must be made an integral part of risk management. This approach, founded on controlled and dynamic management of risk budgets, makes taking into account short-term constraints less costly than it is with static allocation.

This controlled and dynamic management of risk budgets can and should incorporate the investment horizon; without this incorporation the long-term approach makes no sense. As it happens, investment in the risky asset depends not only on mere respect for short-term constraints, seen as a cushion over a floor for the value of the assets or gains an investor seeks to protect, but also on changes to the risk premia and on the volatility of risky assets, which can act as counterweights to the rise or fall of the cushion. So, if the modelling of variations in the risk premia in stock markets suggest a reversion to the mean, the reduction of the risk budget caused by falls in stock prices in sharp downturns will be offset by an increase in the long-term returns in stock markets that have become, as it were, less expensive.

The dynamic management of risk budgets ensures that portfolio insurance and life-cycle approaches are compatible, compatibility that is the very foundation of long-term asset management. This is the core concern of the research we are doing as part of the BNP Paribas Investment Partners research chair on Asset-Liability Management and Institutional Investment Management.

Solvency II

The notion of risk management proposed by Solvency II is inappropriate, as it rests on VaR, control over which will presumably be done by diversification. But diversification does not ward off extreme risks; it serves mainly to improve the long-term performance of a portfolio of risky assets. The illusion of econometric sophistication should not make us overlook this principle of modern portfolio theory. Only dynamic management of risk budgets and, more broadly, risk insurance, make it possible to meet objectives for the solvency of insurers all while investing in risky assets. Calculating capital requirements by relying on maximum losses over one year for different categories of assets inflicts handicaps and is unrealistic, as investors can put stop-losses in place or, better still, rely on strategies that ensure that solvency ratios are sufficiently high. The capital requirement should be limited to the residual risk from the model and from the dynamic management of risk budgets. To have current allocation determine the economic capital requirement is, quite simply, wilfully to ignore thirty years of research in finance.

Accounting standards and risk management

Accounting standards do not foster dynamic allocation strategies because assets are held to maturity to keep their volatility in check artificially. They thus encourage behaviour that, from the point of view of risk management, is not optimal. Accounting principles should be reviewed in the light of good risk management practices; in addition, hedging techniques founded on systematic allocation rules should enjoy the same recognition as static hedging strategies do. More broadly, taking into account the interaction of prudential and accounting rules is a major issue for EDHEC-Risk Institute, an issue we are examining as part of a pan-European research chair on Regulation and Institutional Investment endowed by AXA IM.

Development of passive asset management

For many institutional investors, risk-taking is ever more costly in economic capital, so it must be done optimally. In this respect, investors’ attachment to capitalisation-weighted indices, which are inefficient and poorly diversified and thus do not offer a fair risk/return tradeoff, boggles the mind. Why keep investing in stock markets on the basis of benchmarks that encourage speculative bubbles made up largely of the most expensive companies? Likewise in the bond markets: it is the corporate issuers, the most heavily indebted, that are represented in the indices. With such drawbacks, it is not hard to improve the risk/return tradeoff of indices or to provide a means of more efficient passive asset management. The new indices created by EDHEC-Risk Institute with FTSE have sought to do just that.

Transfer of risks to individuals

The disappearance of defined-benefit pension funds in favour of defined-contribution pension funds and the need for investors in search of returns to count on life-insurance policies in units and not only on funds in euros, the performance of which will be heavily penalised by Solvency II, have resulted in the risks of asset allocation being transferred from experienced professional investors to less experienced individuals. But the horizon funds on offer in response to the lack of allocation experience of these investors are not the answer. By assuming that only time need be taken into account, they neglect an element essential to long-term allocation: return variation and asset risks. This neglect leads to management of risks that is highly primitive and likely to overlook market conditions. It is not because the retirement horizon is distant that an investor should invest the bulk of his savings in a speculative bubble. Optimising the management of horizon funds is the subject of research, the initial results of which are highly promising, done by Professor Lionel Martellini as part of the UFG-LFP research chair on Dynamic Allocation Models and New Forms of Target-Date Funds.