Rodgers Investment Consulting - Counselling

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Counselling - RISK TOLERANCE

ASSET MIX RISK

Risk is normally defined as the potential for volatility when time horizons are long as is the case with this fund. Risk is controlled through the use of different asset classes that will perform in different ways given a specific set of capital market or economic scenarios.

In general, over long time horizons equities are used to obtain growth while bonds and cash are used to moderate the volatility of returns. It is not an unusual event to experience years when a specific asset class declines 20% or more (Canadian equity 12 months ended September 30/99). Less common is two successive years of substantial down markets.

Less common is a single year period when balanced portfolios suffered losses and more unusual still are two successive years of balanced fund declines (1973 and 1974 with balanced returns down a percent or two).

The ability to tolerate short term volatility and the desire for long term growth determine the benchmark asset mix. This is strongly impacted by the funding policy of the organization and outlook of the Board.

Experience in balanced funds with primarily Canadian equity exposure indicates that an equity weighting of about 60% is optimal. U.S. experience is more strongly biased towards equity due to the greater difference between fixed income and equity returns.

The greater the range for shifts in the asset mix the more potential risk a client or manager is assuming.

CAPITAL RISK

Tolerance for losses within each asset class is controlled or managed through diversification within each asset class. More securities are purchased to reduce the potential of any single loss experience having a catastrophic impact on the overall portfolio. There is no clear answer to the question of how much diversification is enough. Estimates range from as little as ten securities in each equity class to forty in each. This assumes that the individual securities are also diversified across industry sectors and capitalization sizes.

Most portfolios hold more than the required number of securities due to liquidity reasons rather than due to diversification requirements. The risk control practices of managers are assessed and evaluated during the RFP process.

OPPORTUNITY RISK

Opportunity risk can be defined as not achieving as much return as was available. Historically many non profit organization were unwilling to take capital risk yet assumed substantial opportunity risk. Over the last decade, investing only in T Bills or GIC=s would have avoided any capital risk but assumed great opportunity risk by giving up the returns available from equity investments.

Opportunity risk will have the largest impact on the organization in the future in terms of its long term ability to maintain inflation adjusted spending levels or generate higher funding levels in future time periods.

In a diversified portfolio opportunity risk can be controlled through the cash portion of the portfolio. The greater the level of cash a manager is allowed to raise, the more opportunity risk is being assumed and the more capital risk is being avoided.

Being completely out of an asset class, such as international equity, would also be assuming more opportunity risk.

BENCHMARK RISK

Benchmark risk is the risk of having returns that are significantly different from the benchmark against which the portfolio is measured. This is not an investment risk but a Board reporting and governance risk. In Canadian equity it is particularly important with Nortel representing over 30% of the TSE 300. Underweighting of Nortel with its large weighting and high volatility has resulted in some managers significantly underperforming the index. The new Capped TSE 300 Index will alleviate this problem for funds that also require diversification.