For decades, the common approach has been information ratio—return relative to a cap-weighted benchmark, divided by active risk. The problem is that this measure misses the point of what most defined benefit plan sponsors are trying to achieve: absolute return at a risk level that will meet their plan’s objectives. How can they measure this, and orient an investment program around achieving it?
Pension plan managers have a difficult task: to ensure the fund’s asset base is large enough that pensioners receive the benefits promised to them during retirement. Pension managers must consider many variables, including market movements, adjustments of contribution rates, and altering demographics of pensioners. Unexpected changes in these and other variables can disrupt the best laid plans.
Finding ways to dampen the volatility of a pension plan’s funding status can be a crucial component of a plan’s long-term viability. This is increasingly a priority in the wake of the Pension Protection Act (PPA) in the U.S., solvency rules in an increasingly number of other markets, and new global international financial reporting standards (IFRS) accounting rules concerning pensions.
We believe investors should ultimately care most about total return and total risk as it relates to their objectives. For a plan sponsor, compounding high absolute returns with the minimum amount of return variability is the straightest path to meeting their obligations. Given this, it is worth considering the fact that the measure used by most plans—information ratio—is not oriented to this objective. By focusing only on “active” (benchmark-relative) risk and return, information ratio:
- Measures risk and return only in relation to a limited cap-weighted index
- Handcuffs portfolios to a benchmark that is typically below the efficient frontier
- Imposes significant constraints on the types of investments a plan can utilize.
Many investors currently allocate using a two-step process, first to the equity asset class, and then within equities, using information ratio. This process typically finds investments focused on absolute return and risk quite unattractive, despite their clear intuitive appeal. In contrast, investors who use Sharpe ratio as their analytical tool will likely see a very different set of asset allocation recommendations.
Sharpe ratio is calculated by subtracting the risk-free rate from a portfolio's average or expected return and dividing the result by the standard deviation of the portfolio returns. The greater a portfolio's Sharpe ratio, the higher its risk-adjusted performance in absolute terms. While not a silver bullet, we believe Sharpe ratio is a highly useful and often overlooked tool in the asset allocation arsenal.
One attractive investment that will look much more viable under a Sharpe ratio lens is low-risk equity strategies. In recent years many plan sponsors have become aware of the potential for downside protection and lower return deviation offered by these approaches, which seek to achieve the market’s absolute return at lower-than-market risk. The historic performance of such strategies suggests they have the potential to deliver equity market-level returns and liquidity at approximately one-third lower absolute risk. If the equity risk premium can be captured at lower volatility, compound returns grow higher and drawdowns grow smaller.
Acadian’s research team has looked into how the funded status of pensions respond if low risk, managed volatility equity strategies are incorporated. We simulated the funded status of plans with and without an allocation to managed volatility strategies, and found those plans with allocations to managed volatility strategies exhibited lower volatility of their funding status. This has important implications for plan sponsors seeking to achieve a higher yet smoother return stream over time.
While obtaining the equity premium at a lower level of risk seems like an obvious benefit, it is not necessarily obvious how to integrate low-volatility strategies into traditional investment allocation programs. Low volatility strategies are expected to produce high Sharpe ratios but not high information ratios, since low-risk stocks generate high benchmark-relative active risk versus traditional cap-weighted benchmarks. Consequently, and in spite of their high Sharpe ratios, low-risk equity portfolios can be overlooked by investors whose primary focus is on benchmark-relative risk and return.
Managed volatility approaches are just one example of an investment that will be attractive to investors focused on optimizing their total risk-adjusted return, but which may be missed by an overreliance on information ratio. While no measure is perfect, by incorporating considerations of total risk and total return—Sharpe ratio—into their asset allocation decisions, plans can manage total risk more effectively and thus be in a better position to meet their objectives.
Ryan D. Taliaferro, senior vice president and portfolio manager at Acadian Asset Management LLC
Acadian Asset Management is a global institutional asset management firm headquartered in Boston, MA.
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.