Responsible fund investment

starts with clever risk management

Responsible fund investment

Fund investment carries specifi c risks for insurers and pension funds. Good fund investment therefore starts with intelligent risk management. Consultant Martijn de Groot shows how, with the help of benchmarks and fund mapping, you can clearly chart the risks involved in an investment portfolio of funds.

What is asset management without investment funds? A fund off ers exposure to various diff erent assets, regions, interest periods, etc. Investment mandates can be contracted out to asset managers by agreeing a certain benchmark or overlay structure. The knowledge, expertise and the possible higher yield this can bring (through active risk) can all be put to use. Smaller players are able to gain favorable access to investments that would otherwise carry heavy operational costs. These are just a few of the reasons why pension funds and (life) insurers make widespread use of investment funds.

From the viewpoint of risk management, however, they bring with them specifi c challenges. The risk involved in a fund cannot be measured simply, nor can it be covered immediately by derivatives. If you want to make a good estimate of the risk of the investments, one way of doing this is to determine the individual volatility of all the funds as well as the mutual correlation. However, this is a complex activity if investments are made in a number of diff erent funds. For this reason it is better to focus on agreements between funds.

Shared characteristics

Firstly, it is a good idea to decide on the level of detail of the survey and not to use all the investment instruments at the same time. The risk of a share in one of the emerging markets is naturally quite diff erent from shares in the established markets. Furthermore, fi xed-rate securities with a high rating have a diff erent risk profi le than securities with a lower rating. This means that a certain amount of distinction needs to be made between, for example, types of investment, regions and ratings.

Instead of looking at the model of each individual fund, look for the qualities that they share which can be modeled. You can use the benchmark of the fund, for example, to do this. The mandate of a fund often contains a reference to a benchmark that should be followed, possibly with a portion of active risk. A benchmark is a set of names or indices that are usually quoted daily. By combining funds with the same benchmarks, you will only need to focus on the risk within the benchmark. This will enable you to make a good estimate of the future development of the portfolio, without needing to simulate every fund individually.

Since pension funds and life insurers have often made implicit guarantees to their participants about the yields from the investment funds, the temptation may arise to remove certain risks. To do this, a relationship must be given between the funds and the derivatives in which trading is possible. No derivatives are available through funds. Not every benchmark includes the possibility of an option or future. This means that the fund or the benchmark must be further related to securities in which it is possible to trade or in which derivatives are available. Worldwide there are many indices in which liquid derivatives are traded, such as, for example, the AEX or the S&P 500. By deploying fund mapping of the benchmark on these indices, the relationship can be sketched for the hedge.

Fund mapping

During the fund mapping process, the benchmark is mapped as well as possible to a set with liquid derivatives (such as index futures). The statistic results of the regression aff ord insight into the quality of the fund mapping. Unfortunately, there is an exponential relationship between the decrease in quality of the mapping and the hedge eff ectiveness. High quality is therefore a must for a good hedge. Including extra derivatives in the mapping increases the hedge quality. Greater numbers of indices in the hedge, however, also bring higher hedge costs. In the end, the results of the fund mapping can be used for determining the hedge strategy, in which the hedge quality must be weighed up against the hedge costs.

Benchmarks and fund mapping, if used correctly, provide a better picture of the risk position of fund investments and make hedging possible. Besides this, it is possible to formulate a detailed ex-post split from the result towards the underlying categories. This will enable the provision of adequate information to the client and, in case of guarantee products and options, the risk can be estimated better and mitigated if necessary.