The Importance of Downside Expectations

Ashby Monk

I’ve long wondered why institutional investors don’t (to my knowledge) put out estimates for “permissible losses.” In other words, why don’t sovereign and pension funds offer their stakeholders an estimate of what would be the maximum short- and medium-term loss that would be deemed “permissible” given specific levels of risk? In my view, this would be a very useful number for any long-term investor to be able to point to should performance turn negative in the short term. For example, the policy could say that unless the fund loses more than XY% in a year or Y% in a five-year period, stakeholders should not interfere in the fund’s operations. Beyond that permissible level, however, a review of operations is required. Such a policy could be quite useful in avoiding some of the legitimacy troubles that many investors had during the GFC with their domestic constituencies.

Well, it turns out I’m actually not all that creative, as I learned this morning that the New Zealand Superannuation Fund (a perennial innovator) has been using a permissible loss estimate in its communication strategy with stakeholders for some time. I saw the estimate for the first time in the fund’s new Statement of Intent, which, by the way, is worth reading in its entirety. (It’s a remarkable document; I could write five different posts from the material in there.) Anyway, here’s a blurb about the NZSF’s “worst case downside return” estimate:

“Financial market returns are inherently volatile. In any given period actual returns will fall somewhere within a wide range of possible returns. For the estimated ‘worst case’ downside return we look at lowest percentile expected return (or a 1-in-100 event) for the period. If actual returns are worse than this, then either a rarer-than-expected event has occurred or we have taken more risk than we assumed.

Our ‘worst-case’ modelling work (based on a 20-year investment horizon, which is also the basis for the Reference Portfolio) suggests there is a 1-in-100 chance of Fund returns being worse than: -31% in any one year; -5% p.a. in any consecutive five-year periods; or -3% p.a. in any consecutive 20-year period. In any such case, we need to explain what has happened (and will do so in the relevant period’s Annual Report).”

That’s actually really cool. And no doubt the estimate will be useful for oversight committees and stakeholders. In a way, the act of publishing a permissible loss level serves to manage the expectations of the fund’s stakeholders. And, crucially, if the fund has public ‘buy in’ for the operations (including potential losses), then the public would (in theory at least) not challenge the viability of the SWF during short- to medium-term downturns in the market (unless of course returns dropped below the permissible level). And this ‘freedom to operate’ has important commercial benefits, as it ensures that the fund’s investment horizon will remain long-term, and that it will never have to sell assets at a discount because domestic stakeholders changed their minds about a certain strategy or policy.

In other words, taking a long-term investment approach requires managing short- and medium-term return expectations (both on the upside and downside). And as I’ve said several times, I think SWFs can generate market-beating returns by taking a long-term view and moving beyond the short-term noise. Perhaps this “permissible loss level” is a useful tool in this regard.

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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