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Be wary of unintended risk

This year marks the 25th anniversary of the founding of the International Association of Financial Engineers, now called the International Association for Quantitative Finance.

There is reason to celebrate financial engineering, which combines finance, investment management, high-level mathematics and computer programming science.

Long before the formation of the association in 1992, financial engineering was part of the institutional investment management landscape. It started with the development of modern portfolio theory from the pioneering work of Harry Markowitz in 1952 and his mean-variance model, introducing the efficient frontier of investments optimizing the risk and return of a portfolio.

Such breakthroughs led to developments in ensuing years to enable the investment of increasingly large pools of assets in efficient and effective ways, reducing costs and improving outcomes. Financial engineering has led to new investment instruments and strategies as well as breakthroughs in trading and custody.

Asset owners must keep pace with the innovations and the challenges they introduce. Innovations often are increasingly complex and put more stress on the financial system, exposing asset owners as well as regulators to new risks.

After the market crisis of a decade ago, some institutional investors were ready to discard financial engineering — which involves structuring investment vehicles, strategies and transactions to contribute to fundamental operational optimization — blaming it for a central role in contributing to large losses in their portfolios, especially from structured investment vehicles, credit derivatives and credit default swaps.

Following 2008 losses, for example, the Caisse de Depot et Placement du Quebec, Montreal, “eliminated much of the financial engineering” as Michael Sabia, president and CEO, wrote at the time in a published letter, largely blaming it for the downturn. “Going forward, we aim to invest only in financial instruments that we understand,” he wrote, and promised a return to “plain old common-sense” principles.

In 2009 Paul Volcker, former chairman of the Federal Reserve System, criticized the investment structures created by financial engineering, including uncertainty in regulation of innovative instruments.

Innovation has led to what some practitioners have called an arms race in innovations in investing and trading, sometimes to the detriment of institutional investors. Rogue algorithms have sometimes led to instability and losses, outrunning investors and regulators in managing risks.

Innovation from financial engineering has sometimes created instability in the markets, from flash crashes to programming errors by even technology-strong firms that have led to losses even for investors without direct exposures.

Thirty years ago, a creation of financial engineering called portfolio insurance — which used computer models to trigger trades to limit losses in a market downturn — was blamed for exacerbating the 1987 market crash as many users attempted to sell simultaneously, contributing to an unexpected systemic crisis.

But the lesson asset owners must learn is the embrace of promises of innovations can be undermined by failure to improve risk management, from an overreliance on credit ratings for structured investment vehicles to a general neglect of market dynamics.

Financial engineering has encouraged the development of higher-level quantitative methods, a better understanding of diversification and the interconnectedness of asset classes and strategies and market stability. It has led to the development of better risk management tools from earlier techniques like value at risk to framing exposures more holistically. It has become a major field of academic study.

At the corporate level, for example, J.C. Penney Co. in 2009 used what it called financial engineering to contribute its stock to its pension fund in a way that raised company earnings by 3% and improved the funding level of the plan to between 104% and 110%. The stock contribution, fully tax deductible, was projected to eliminate all taxes due and payable for the year, enabling J.C. Penney to use the cash in a financial arbitrage opportunity to buy back debt, deleveraging its capital structure. In addition, the improved funding level enabled the company to move its pension fund to liability-driven investment, another financial engineering technique, to reduce pension plan and corporate balance sheet volatility.

Trustees must embrace data management as critical in the use of financial engineering to improve return and risk management outcomes.

The State of Wisconsin Investment Board has been a pioneer in embracing management of data as part of its investment and risk management infrastructure. In January, it posted a search for a data management director.

In investment management, financial engineering has disrupted active management through longtime innovations such as indexing and newer techniques like portable alpha and smart beta.

In trading and custody, it has led to the development of high-frequency trading and blockchain technology, creating innovative trading and custodial platforms.

For defined contribution plans, financial engineering has enabled the creation of target-date funds, the fast-growing segment of the market embraced by sponsors to help participants manage asset allocation risk and return.

But none of these innovations has come without some bad or unexpected outcomes that asset owners could have minimized or avoided with a greater understanding of the underlying financial engineering.

Algorithms aren't running the markets, but financial engineering is extending its reach in institutional investing.

In terms of setbacks and uncertainties, asset owners have the ability to manage risk and improve outcomes. But to improve their chances they must strengthen their harnessing of financial engineering in risk management to help guide their investment decisions in dynamic markets.

This article originally appeared in the February 20, 2017 print issue as, "Be wary of unintended risk".