A Useful (But Painful) Risk-Management Lesson from the Chilean Pension System

Abstract

This article demonstrates the dangers of attempting to create investment funds with different risk-return profiles by relying only on investment policies based on asset class-limits, but without incorporating portfolio-level risk constraints. The analysis is based on a natural experiment: the Chilean pension system. The study considers monthly returns data from the five investment funds that constitute the bedrock of the Chilean system and covers the period October 1, 2002 to June 1, 2020. The analysis, which relies on the use of different rank-order metrics, shows that the five funds delivered returns incompatible with their intended risk-return profile. In short, rank-ordering the five funds based on their cumulative returns resulted in a sequence at odds with the original intention; that is, contrary to the regulator’s aim, riskier funds frequently delivered lower returns. These findings are relevant for policy makers and the private sector, as many institutional investors (not only pension funds) based their investment policies on such limits alone.