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."
During the second half of 2011, as well as during the 2008 global financial credit crisis, volatility rattled financial markets and rendered investors nervous. As a result, new products specifically built to address volatility in investors' portfolios have been emerging.
"The volatility we've observed in the market in the last decade has been nothing short of extreme," said Jennifer Young, CFA, President and Co-Chief Executive of INTECH Management LLC, which has $38 billion in assets under management as of Sept. 30, in both large-cap U.S. and global equities. "This creates an environment for investors where the challenge is that it is more difficult to determine how to best measure and manage risk. Clearly, a focus on risk management in an increased-volatility environment is something we are seeing more and more."
The financial crisis of 2008 impacted hedge funds like all other market participants, exposing deficiencies in their management of risk, although it has since improved, making hedge funds more transparent and institutional investors more willing than ever to incorporate them into their portfolios.
Hedge funds' managers have always made a point of trying to control risk efficiently. "Prior to 2008, hedge fund managers had a very large focus in terms of controlling their tail risk," said Corey Case, Chief Operating Officer and Co- Head of J.P Morgan Alternative Asset Management. "They've always done a good job at controlling that space historically."
But many investors complained that hedge funds also lacked transparency and as a result some have traditionally refused to have a hedge fund exposure. But this is changing.
Risk management has significantly improved in the past decade, an evolution that was further accelerated by the 2008 global financial crisis.
The types of risks present in financial markets have also changed and the professionals who focus on risk management are now asked to do much more. More importantly, investors have come to realize that enhanced risk management has become an inherent part of their strategies.
"Risk management was bolted on, but that's changed," said Arvind Rajan, Managing Director and Head of Quantitative Research and Risk Management at Prudential Fixed Income. "In many shops that take risk seriously, it's in-house and built into the investment process." Rajan added that risk management has gone from being "a nice thing to have" to "indispensable."
Since every investment contingency cannot be foreseen, one way to avoid being blindsided is to allow flexibility through the risk budgeting process.
"Often the process of changing investment guidelines is slow and cannot keep pace with market developments," said Arvind Rajan, Managing Director and Head of Quantitative Research and Risk Management at Prudential Fixed Income.
Rajan suggests that since modifying investment guidelines to adapt to new market conditions can be cumbersome, some room could be built into the investment guidelines to allow the portfolio manager to respond rapidly to market changes.