Boards and executives of long-term funds, such as pension plans, sovereign wealth funds, and endowments, need to manage portfolios to meet their long-term purpose, which may be decades or more into the future.

In Balancing Act: Managing Risk Across Multiple Time Horizons, FCLTGlobal describes how laying out the goals and parameters of a fund can lead to a deeper understanding of the fund’s needs and provide greater conviction to maintain a long-term outlook in the face of market stress.

Denmark’s largest pension and social security provider, ATP, takes as its stated purpose to help ensure basic financial security and efficiently secure the welfare of its beneficiaries. This approach is reflected in a recent paper, A Balanced Factor Approach to Investing, where ATP’s heads of portfolio management outline the fund’s investment framework, including their investment beliefs and risk appetite threshold.

Investment Beliefs

Investment beliefs are strongly held and clearly articulated views about investing. It is important that these views reflect the realities of the fund’s purpose and liabilities. For example, one fund might say that market prices will deviate significantly from fundamental or intrinsic value in the short run, while another might say that markets are efficient, with few opportunities for mispricing. Clearly, those different beliefs could lead to very different investment strategies.

ATP states its investment beliefs as the following:

1. A positive relationship between investment risk and investment returns. An investor requires more return from an investment the more the investor perceives the investment risky. However, not all investors perceive investments risk the same way.
2. The rewarded risk can be attributed to a small set of risk factors. These risk factors span the risk across the investment universe and over time. Managing these risk factors is the most important task to obtain diversification and stable returns.
3. Asset returns are stationary and we can infer information from the history using statistical tools. However, we include a sceptical view on investment determinism and the ability to calculate ‘‘optimal” allocations based on return-statistics. Investment indeterminacy and structural uncertainty make the strategic focus more about getting the risk picture ‘‘roughly right” than being ‘‘precisely wrong” on the return expectations.

Research suggests that successful investors tend to maintain their investment beliefs. Among the global asset owners who responded to our 2018 survey, those that added net value (relative to their own internal policy benchmarks) over 10 years tended to stick to their investment beliefs for three years or longer. Conversely, those that did not outperform their benchmarks were more prone to departing from their stated investment beliefs in less than two years.

Risk Appetite

While investment beliefs guide strategy, a risk appetite statement acknowledges both the amount of risk required to achieve the long-term desired outcome and the amount of acceptable interim loss. Such statements establish the risk framework by clarifying the willingness and ability to sensibly take risks and accept uncertainties. Below, ATP provides an overview of the various types of risk it anticipates and how they measure them:

Some funds consider risk appetite quantitatively, such as “We expect active risk to be 4 percent on average and no more than 8 percent.” Others set their threshold in qualitative terms, such as “Our conservative posture means that we will underperform in strong markets and outperform in weak markets.” In ATP’s case, they leave this decision to the investor depending on their goals:

“The application of the factors on asset allocation decisions is left to the investor in the context of her specific investment objective, liabilities and constraints. Each factor defines a unique set of “bad times” or periods of underperformance. Investors must select factor exposures that cater to their comparative advantages and compensate them adequately for the accepted factor risk.”

Practical management requires investors to assess both their need and tolerance for risk. The same 2018 survey shows an overlap (78%) between respondents who use a risk appetite statement and those that added net value over ten years.

Managing a fund’s portfolios across various time horizons forces even the most long-term of investors to meet both short- and long-term obligations. However, many risk processes in use today have been developed to either address short-term risks or to target long-term return—but not both. Using mechanisms such as those above can help managers set the right expectations, build alignment on strategy, and most importantly strike a balance between a fund’s interim performance and longer-term objectives.

To learn more about our research on long-term portfolio risk, please refer to our recent work, Balancing Act: Managing Risk Across Multiple Time Horizons. For updates on new and upcoming work from FCLTGlobal, follow on social media @FCLTGlobal.