In November 2013, Casey Quirk & Associates published a thought piece called “Life After Benchmarks: Retooling Active Asset Management.” In this publication, Casey Quirk argued that asset owners will increasingly shift money away from benchmark-oriented products towards what they call “New Active” asset management.

In contrast to the current approach, where investment firms attempt to match and beat some sort of return bogey (such as the S&P/TSX Composite Total Return Index or an absolute return target), the New Active approach will use an outcome-oriented asset allocation approach that gives the asset owner the best probability of meeting future cash-flow needs. The analysis requires assumptions about future risk and return levels across asset classes. The outcome of the analysis is a targeted portfolio of risk factors such as duration risk, equity risk, and idiosyncratic risks (illiquidity, scarcity, relative value, arbitrage opportunities, event-driven strategies, and so forth).

In the current approach, an asset owner may choose an asset allocation based on historical returns, such as a 50/50 asset allocation between fixed income and equities. The asset allocation is usually very static, and periodic rebalancing occurs to bring the asset mix back to target weights. The fixed income and equity manager(s) are given specific return bogeys to meet and are evaluated, in part, on how their returns compare. With the New Active approach, after determining future cash-flow needs, the asset owner will use prospective risk and return levels for a variety of asset classes in order to determine the ideal current asset mix. However, the asset mix under the New Active approach will be more dynamic because risk/return trade-offs change over time. In other words, if an equity market got riskier due to an increase in prices, without a corresponding increase in earnings, the risk/return fundamentals for equities would decline. That could cause the asset owner to reduce the equity weighting for an asset class with a more favourable risk/return trade-off.

Beyond the Beauty Contest

So what does this mean for asset managers? If New Active asset management becomes more prevalent, asset managers will need to understand their own risk/return trade-offs so they can explain return expectations for a range of risk levels to a prospective client. Benchmarks, as they are used today, would be rendered irrelevant for firms using New Active asset management because asset managers would be targeting a specific level or range of risk in order to get to an expected return. The decision to hire or fire a manager would then be based on the ability of an asset manager to invest to a risk level within their asset class and on how much return is earned per unit of risk taken when compared to their peers. A consequence of the New Active style is that a firm that generates superior risk/return characteristics might not win a manager search if they do not demonstrate an ability to control risk levels taken to earn their returns.

This concept is not new but is rather an iteration of risk budgeting with a twist: implementation would move to the investment manager, whereas the responsibility previously resided with the asset owners and strategists. Traditionally, an asset mix was designed using backward-looking risks. This is much easier than using forward-looking results to determine asset mix, as the article suggests. The added complexity of forward-looking data creates issues with implementation because there is no perfect crystal ball or way of accounting for unknowns, nor is there any evidence that individuals are better at guessing prospective metrics than they are at market timing. Concerns include problems with risk budgets, transparency, timely information, and the asset managers’ ability to deliver a promised or consistent result.

Traditionally, sensitivity to risk factors was an outcome of the asset mix process, but the New Active approach shifts this responsibility to the asset manager as an input into the process. Additionally, the use of prospective scenarios gives managers of each style large incentives to downplay risks that do not specifically deal with their strategy and to promote only the risks they are prepared to manage. At the same time, the asset manager may not have a holistic picture of the risk they should manage. Since prospective risk and return characteristics would be at the discretion of the asset manager, the allocation of fiduciary responsibility will need to be addressed. There is also the issue of how Global Investment Performance Standards would address compliance with the New Active approach.

Using prospective risks, a small change in the future risk or return characteristics could translate into large changes in asset mix and subsequently asset manager structures. Implementing a multi-manager risk-factored structure will bring with it additional questions, such as: If one manager misses their target, will the entire program fall apart? Or if factors don’t move in expected directions, will liabilities be met? There may be trade-offs to consider, such as widening the targets to increase the probability of success, but if they are too wide, will there be any benefit to following the process? The added complexity means that only the larger asset owners would be able to do the necessary work in generating prospective risk and reward characteristics across a variety of asset classes and strategies. Furthermore, prospective metrics can change on a daily basis, which would then require that the framework is frequently adapted with changes to the asset mix or asset manager. Frequent changes to a multi-manager structure would bear a substantial monetary and resource cost to the asset owner. Oversight and monitoring will become much more sophisticated, which makes this good news for consultants who adapt and offer to run this service. Understanding the nuts and bolts of implementing the New Active approach will require a very clear understanding of which risk factors play the biggest role for both the asset owner and the asset manager.

Determining the skill of a manager to meet a risk objective would require more skills and a new set of unproven metrics or the ability of asset owners and managers to analyze these factors. The role of assessing what an asset manager is capable of should reside with an asset owner, along with the task of educating themselves and their boards on what risks are important to them. Asset managers need a goal to manage to, but when they provide the target themselves, there is a loss of prudence and fiduciary independence. When evaluating managers, asset owners should focus on the asset manager process that has led to specific objectives. After all, as the saying goes: “Past performance is not indicative of future results.” The benefit will be a clearer and more transparent presentation of what the investment manager is capable of.