The market sell-off that started in the summer brought back to investors' minds vivid memories of the financial crisis of 2008 and 2009 when asset prices plummeted, volatility spiked, correlation between asset classes rose and uncertainty spread quickly.
While some investors had learned lessons from 2008 and already reinforced risk management, others are now realizing that a sound risk management strategy has become essential to protecting an investment portfolio.
"The events of 2008 and the last few months, in particular, have placed a strong focus on risk and how best to manage risk," said Jennifer Young, CFA, President and Co-CEO of INTECH Investment Management LLC, which was founded in 1987 and has $38 billion in assets under management as of Sept. 30. "Investors are focusing on risk, now more than ever."
Many traditional risk management techniques such as securing safety in bonds and diversifying portfolios failed to fully protect investors. Facing heavy losses coupled with the global pension crisis, institutional investors are now dealing with an increasingly challenging investing environment.
There's no evidence that new risks have emerged in financial markets. But some risks that hadn't been seen in the markets for some time resurfaced while other risks intensified. Current acute risks include heightened volatility, liquidity risk, interest rate risk, and both deflation and inflation. Investors are also more aware of risk in financial markets affecting their portfolio because global event risk has increased, the length of economic cycles has become shorter and the frequency of financial crises has gone up. Investors are expressing broad disenchantment and a renewed need to understand risk is emerging.
Investors' attention also seems to have shifted from relative risk, which is the comparison between different risk levels, to absolute risk, which is pure probability of risky events occurring, or risk without context.
"In the past, risk has typically been thought of from a relative standpoint in most mandates," said Young. "It's been about beating the benchmark. Over the past few years, primarily due to extraordinary downside events, investors have started to re-orient their thinking on absolute risk and absolute return. The thought is that perhaps it's more reasonable to give up some of the upside return in a good market to mitigate extreme risk in a down market."
To best understand risk and make sure investors have the most exhaustive approach to risk management, experts recommend that risk management be incorporated in the investment process from its beginning.
Sometimes, a lower level of reward and a lower level of risk might be better to avoid blow ups and guarantee consistent returns. At INTECH, for example, reward and risk are intrinsically connected in the firm's investment process while other processes may overlay a risk-management model once return drivers are identified, according to INTECH's Co-Chief Investment Officer, Adrian Banner, Ph.D. At INTECH, risk controls are embedded in investment engineering, an approach that may curtail extreme positive returns but is designed to shield a portfolio from extreme negative returns.
Prior to 2008, investors thought they understood risk – that they could manage risk simply by implementing a sound asset allocation strategy. Since 2008, however, investors have come to realize that risk management, a key component of long-term alpha generation, must be applied at the portfolio level and perhaps even more deliberately at the asset allocation level.
"The endowment and foundation community's broad dissatisfaction with risk management of their portfolios began with their reliance on understanding risk from an asset allocation viewpoint," said Anthony Werley, Chief Strategist of the Endowments and Foundations Group at J.P. Morgan Asset Management.
The asset allocation model has been the basic method for risk management at an early stage of construction of an investment portfolio by using standard asset class buckets such as equity, fixed income and alternative investments and looking at the risk associated with each manager. But it has been criticized for being too opaque, especially for global multi-asset portfolios. While it shouldn't be forgotten altogether, there are other methods that should be supplemented to have a more transparent vision of risk.
"At the very beginning of the investment process— strategic asset allocation— risk was underappreciated since traditional asset allocation perceptions of risk are too narrow to judge the magnitude of risk taken in any but a normal environment," said Werley. "The endowment and foundation community is shifting to more insightful and accurate means of organizing their risk framework, specifically factor-based allocation and objective- based allocation."
The focus of investors also seems to have shifted from relative risk, which is the comparison between different risk levels, to absolute risk, which is pure probability of risky events occurring, or risk without context.
Factor-based allocation breaks down market-related risk into four to five categories based on market exposures, but not by asset classes or management format. "In a factor framework, risk is understood in terms of exposure to various market beta such as developing and developed market equity, credit and government fixed income beta, foreign exchange beta, commodity beta and so on," said Werley. Risks in all asset class, which could include roughly 30 managers, are categorized according to these buckets but without paying attention to managers' records. For example, an allocation to a fund manager focusing on long and short equity investing and a hedge fund manager focusing on event driven strategies like merger arbitrage will at least in part be categorized in the equity risk bucket. Under the asset allocation model, they would have been classified in the alternatives bucket. As a result, factor-based allocation provides a much finer and deeper understanding of risk.
"By looking through asset allocation and including the market exposures that managers and other execution vehicles take on, we have a more accurate and thorough understanding of the portfolio betas," said Werley. "Factor risk is the sum of market beta from asset allocation through execution vehicles."
Factor allocation models have been around for a long time, and have particularly been popular with hedge funds and multi asset-class managers. But they are now being applied again on a more frequent basis because of the recent heightened view of risk. "We get a lot of requests on factor models," said Werley. "It's frequently asked for at the CIO and investment committee level."
In reaction to the inadequacy of asset allocation models, another more recent approach, the objective-based allocation model has emerged and aims at building portfolios in such a way to meet certain financial objectives while minimizing risks.
"Objective-based allocation organizes a portfolio's assets by the different functions of those assets," said Werley, citing return-generating assets as the core objective, as well as liquidity-purposed assets and assets for inflation and deflation.
Experts reckon that all three perspectives are good models that should be used together because they all address different types of risks, although the asset allocation method has shortcomings. "We believe all three methods of organizing and understanding risk have a role to play but the traditional asset allocation approach does not lend perspective on illiquidity risk, asset convergence or correlation risk and beta risk that exists beyond asset allocation," said Werley.
When building a growth portfolio, which represents the portion of a fund where investors seek to take risk with the goal of outperforming their liability stream, risk mitigation and tail risk protection are highly relevant. "A growth portfolio that is managed with less downside risk goes a long way toward helping us achieve a smoother ride," said Jeffrey Geller, Chief Investment Officer for J.P. Morgan Asset Management's Americas Global Multi-Asset Group.
"Pension plans are increasingly liability-oriented," added Gabriella Barschdorff, Client Portfolio Manager at J.P. Morgan Asset Management. "There's been a refocus on risk from a liability perspective over the past 10 years. Very few pension plans say it's all about the long term and don't care about bumps on the road."
An allocation to alternative investments is one way to manage a growth portfolio for clients interested in achieving a smoother ride. "There's a liquidity premium to be earned and the return pattern at the expectation should be diversifying and accretive to the exposures they hold with long-only equity managers, which is where the largest concentration of risk typically is," said Geller. But alternatives can be highly illiquid in times of stress and investors should always have a good sense of their current exposure to illiquid assets. "You have to size this allocation appropriately, recognizing that this won't be the natural ‘piggy bank' to get funds for benefit payments or rebalancing in a time of stress," said Geller.
The next types of decision to consider are allocation decisions across asset classes to mitigate risk on the downside. Geller explained that if investors think high yield will deliver a comparable expected return with less downside risk than equities, "a shift from equities to high yield can represent a hedge that over a two to three yearperiod may not be very costly," he said.
These types of risk mitigation decisions can also be done within asset classes and can entail reducing an allocation to long-only equity managers to fund highlyskilled long and short equity managers or event-driven managers. "These steps around proper sizing of allocations and decisions taken across and within asset classes can go a long way toward mitigating risk," said Geller.
LDI also entails hedging. The hedge portfolio typically includes some combination of long-duration bonds and derivatives to achieve a desired duration hedged position. "But a tail hedge or an option hedge is the last decision, not the first decision taken in this process," said Geller.
There are several ways to gradually reduce risk in a portfolio, but the focus is mainly on managing the shift between the growth portfolio and the hedge portfolio in a LDI strategy. One way is to decrease the risk in the asset allocation as the funded ratio improves. He said that investors can also follow a concept similar to that of target date funds in defined contribution plans, where investors can gradually change asset allocation based on the passage of time. Valuation-based triggers is another way – derisking as certain rate triggers are met, for example.
"We typically see a combination of all three with pension plans," said Barschdorff. The second option, the time-based option, is only for pension plans that are willing to contribute to shortfalls, while the most ambitious and difficult strategy is to have valuation-based triggers. "A lot of pension plans are waiting on the sidelines to act at certain rate levels," she said. "The danger with that strategy is that you wait and never hit the trigger. The better concept is to have a strategy that uses all three components. The comfort is in having a strategy and a plan."
If investors are still concerned with the downside risk from a smaller allocation, put options can play a useful role to hedge downside. "Our preference is to focus on direct hedges," Geller said. "So if the dominant risk is to the Standard & Poor's 500, we would hedge with S&P options." Put options allow for more breathing room and a less bumpy ride.
Different companies may have different risk appetites when managing the shift between the grow portfolio and the hedge portfolio in a LDI strategy. "The amount of risk taken, both the size of the duration hedge and the composition of the growth portfolio is very much linked to the client's corporate objectives and their ability and willingness to take risk," said Geller. A company in strong financial shape with a young workforce can afford to take more risk to close a funding gap than another company with a similar funded ratio but a more mature plan and perhaps a more leveraged balance sheet. "We need to take this into account both in terms of the initial size of the duration hedge and the composition of the growth portfolio," said Geller.
"Figuring out the right hedge is challenging because there's no perfect hedge," added Barschdorff. "Striving for great precision in the hedging portfolio is often not worthwhile unless the plan is invested almost exclusively in long duration fixed income. For a typical plan with a big portion of their assets in equities and other assets with no correlation to liabilities those risks will remain regardless of the fine-tuning of the hedge portfolio. But over time, this approach can lead to much better results."
There are several ways for investors and managers to manage risk in portfolios. While the focus is currently on risk management due to the recent market environment, it remains to be seen whether investors stick to their risk management techniques or whether these techniques take the back seat to the benefit of boosting returns, if and when market conditions improve and return to normal. Experts are recommending that investors have a strong risk management strategy in good and bad times.
"Risk management is critical to our process, not just as a means to protect against the downside, but also to preserve the upside," said INTECH's Banner. "Focusing on risk controls in good and bad markets enables us to recognize that markets will become more or less risky; our process will adapt to changing conditions and analyzes risk as part of its alpha-generation model, not as an overlay to the process."
"The marketplace tends to emphasize risk management when markets are extremely challenged," said Young. "But risk management should always be a primary consideration for investors in every market."
Risk is a double-edged sword, she added. "In today's environment, investors' attention to risk has been more acute because the extreme volatility has led people to see clearly the other edge of that sword," she said. "The extraordinary events of the last decade have led to a primary focus on two things: identifying alpha-generating strategies, and finding strategies with a specific and central commitment to risk management. In our view, more-consistent returns and less risk of blowing up are attractive outcomes and hence, a risk-managed strategy makes sense.
J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.