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Investing

Levels of risk for institutions up for debate

Despite volatility fear, some investors need to be bolder — but smart about it

Northern Trust's Wayne Bowers
Northern Trust's Wayne Bowers: '[I] get the sense that clients have been worried a lot about the political environment, and that has reduced their risk appetite.'

Money managers and consultants are split on whether institutional investors are taking enough risk in their portfolios, amid a backdrop of continued support for risk assets, dissipating geopolitical concerns and a synchronized and improving growth story around the globe.

The overarching conclusion: Investors need to be smarter when it comes to how they take investment risk.

Bank of America Merrill Lynch's July Global Fund Manager Survey, with participation from firms with $586 billion in assets, found the average cash balance was 4.9%, down slightly from 5% in June but still above the 10-year average of 4.5%. A bearish view on markets was cited by 25% of respondents for their overweight cash position.

"We know many investors have been nervous around taking risk," said Richard Turnill, global chief investment strategist at BlackRock (BLK) Inc. (BLK), speaking at a July media briefing in London.

He acknowledged fears that volatility could be about to rise but said the firm's analysis suggested it could remain lower for longer. "A real challenge could be many investors are not taking enough risk in their portfolios," he said.

Northern Trust Corp.'s Wayne Bowers, London-based executive vice president and CEO of asset management for Europe, Middle East and Africa and Asia-Pacific, said executives there "have informed clients they should be taking risk" in portfolios. While that may be a challenge for certain types of investors such as more ​ mature defined benefit funds, he does "get the sense that clients have been worried a lot about the political environment, and that has reduced their risk appetite, which means that they don't have enough risk in their portfolios," he said.

David Riley, head of credit strategy at BlueBay Asset Management LLP in London, said a good environment exists for risk assets. While it likely to remain so for some time, it is important to distinguish between the short and long term.

"Investors should be invested and they should be taking risk in the current environment — risk assets offer a good risk/reward profile," Mr. Riley said. "In as much as you have a lever that you can move to adjust your portfolio at relatively low cost within a broader, longer-term framework, you should be pushing that toward adding and increasing risks, in terms of return, into your portfolio."

He acknowledged some pension funds are constrained, so are looking for predictable cash flows and income, considering how to do that without necessarily increasing the public equity component.

Maintaining risk

Some sources said the issue is not necessarily about taking too much or too little risk, but rather maintaining what they have and being smarter in the process.

The €36 billion ($42 billion) Fonds de Reserve pour les Retraites, Paris, has not made many changes with regard to risk. Throughout recent European elections executives kept the portfolio close to its benchmark, which has more than 40% exposure to equities and is just over half allocated to risk assets including emerging markets debt and high yield, said Olivier Rousseau, executive director. "And if anything, we were overweight the eurozone, so basically we made the decision that the odds that there would be no political catastrophe in euroland were high enough to justify our being exposed to the best market in our opinion in terms of valuation — and that is the eurozone."

Mr. Rousseau said executives use put spread collars to protect the portfolio, giving up a bit of upside to "give ourselves a good protection if the market falls." That is a "very comfortable thing to have," and the use of put collar spreads falls under the fund's benchmark. "But (the) reality is today we have more than our benchmark … because we don't see potential in the American market — on the contrary, we fear that adverse developments are possible but we are not sure enough to simply sell all the American equities. It is a good compromise," Mr. Rousseau said. "Even in Europe we are slightly overweight in our put spread collars … it is a precaution note in a generally positive approach in the eurozone."

While every fund is unique and risk appetites differ, greater opportunity for improvement exists in terms of "the extent to which trustees are making their scheme assets work as hard as possible — i.e., how risk is being deployed in order to maximize the expected return for the risk being taken," said David Curtis, London-based head of institutional business U.K. and Ireland at Goldman Sachs Asset Management. "We believe that diversification … is an important tool in maximizing returns for a given level of risk," said Mr. Curtis. GSAM research shows that while FTSE 350 company pension funds have reduced their exposure to equities by 13 percentage points since 2011, the average fund still allocates around 63% of growth assets to equities, meaning "they remain highly susceptible to equity market shocks."

Hold on but stay smart

For the part of the client base not on a derisking path already, consultant NEPC LLC is advising maintaining and acting smart on risk. Phillip R. Nelson, principal, director of asset allocation at the firm in Boston, said there are a number of reasons for this.

"When you look at political risk across the world everything has turned out a little more positive than people expected … and the Fed has been very clear about what their process is, and it's a gradual, methodical approach that has taken the surprise out of the markets. That supports volatility being low. We've said don't necessarily take more risk, just be smarter (about) how you are taking risk — look at the fundamentals in the marketplace to (work out) how you can reallocate that budget," he said.

Thinking smarter about asset allocation has been an important aspect of DB fund investments observed by Gordon L. Clark, professor and director, Smith School of Enterprise and the Environment, Oxford University, England. He has seen a trend in DB funds over the past five to seven years toward risk largely in an effort to make up for the ever-growing gap between liabilities and assets. "Discount rates are very low and could remain low, particularly in the European context."

Mr. Clark cited moves into emerging markets, the U.S. as a growth story and unlisted real estate and infrastructure as ways investors have embraced risk over that time.

David Kabiller, founding principal at AQR Capital Management LLC in Greenwich, Conn., said a typical 60/40 portfolio "is currently valued at one of the most expensive (levels) it's ever been, which doesn't bode well for expected returns. Given most individuals' saving status, investors have to make choice" — save more, cut spending or take more risk — "because doing nothing will not get to the returns you need to achieve a secure retirement." He said one option is to take "intelligent risk – there are risky ways to do things by levering up more, buying more concentrated things, but all investors need to remind themselves of Finance 101 — are they diversified? You want to make sure you are taking intelligent, well-compensated, uncorrelated risks."

And any conversation about returns must have risk as a starting point, said Eugene Podkaminer, senior vice president, capital markets research at Callan Associates Inc. in San Francisco.

"There is a myopic focus in this industry on returns, and without examining risk, returns are meaningless. I believe very strongly that risk is what needs to be focused on — risk can be managed and controlled, unlike returns. From that perspective, given what's happening in the macro economy and the internal pressures that asset owners are under, there is a frequent reassessment of risk," he said. "It doesn't always start from the premise of taking too little — sometimes (the conversation is) are we taking too much, or is it the right type of risk."