An enduring fear of derivatives-linked losses is prompting many institutional investors to continue to question risk in all areas of their investment processes.
Reactions vary as to how institutions plan on managing the ever-growing arsenal of derivatives securities.
For some institutions, the reaction has been to limit or eliminate derivatives from portfolios; for others, it means learning more about ways to manage risk in order to profit from it.
Most institutional investors probably fall somewhere in between, industry participants say.
"I think you have the whole range of plan sponsors taking on different aspects of risk control," said Michael Jensen, manager, U S WEST Investment Management Co., Englewood, Colo., which runs the almost $10 billion U S WEST pension plan.
Some plan sponsors have one person totally devoted to risk management, while others are doing nothing, he said.
While the issue of risk control is an old one, major derivatives-linked losses have heightened awareness among plan sponsors, Mr. Jensen said.
He said plan sponsors took even more notice after the Department of Labor issued a letter on derivatives earlier this year (Pensions & Investments, April 1).
"Some of the smartest (investors) are looking at the science of risk management from a research and development point of view," said Waite Rawls, principal with Ferrell Capital Management, a risk consultant and money manager in Greenwich, Conn.
Current risk management theories and applications were developed from a trading desk perspective, not the long-term investment view of the pension funds and money managers, he said.
Hence, the fundamentals of how to apply the forward-looking view of risk management to pension portfolios is still being developed, Mr. Rawls said.
Executives at the Virginia Retirement System, Richmond, found that to be the case when they began the process of revamping their risk management processes.
"Everyone is interested in this, but nobody's doing it in an all-encompassing fashion," said Nancy Everett, managing director.
So officials are trying to put together a risk management process that works and is still affordable.
Ms. Everett noted it wasn't so much a matter of creating risk management procedures as bringing together different sets of procedures from various areas into a single, documented process. Disaster recovery, for example, is managed in one area, while monitoring of external managers is handled in another, she said.
"We've all got to figure out what's prudent and what's practical," she said.
So officials tried to assess who should do what in terms of risk management, from both the individual unit perspective and an aggregate perspective.
For example, Virginia executives assessed the role its custody bank, Mellon Trust Co., Boston, should play as a possible repository of the information needed for risk management. Virginia executives were involved in beta testing Mellon's new risk monitoring system (P&I, July 8).
Virginia officials also polled other large pension plan sponsors on policies and procedures to try to come up with the best fit for Virginia within reasonable costs.
Ms. Everett said much of the impetus for the risk management assessment came from the derivatives losses taken at big institutions over the past couple of years. She noted that while Virginia uses derivatives in its portfolios, it does not allow the use of leverage.
A single document of risk management controls and procedures is expected to be in place at Virginia by year end, although the risk management process will never be finished, Ms. Everett said.
Risk management is a continuing process at other funds also.
The $66 billion Florida State Board of Investment, Tallahassee, with $52.5 billion in pension assets, has been working on updating its risk management controls for several months.
Florida's acting executive director, Barbara Jarriel, said its four-step risk management review process is on schedule.
The first step, identifying the various types of risk the fund faces as an investor and an organization, has been completed.
The second step, reviewing policies for possible enhancement and development, is underway, Ms. Jarriel said.
Following that, Florida will review its compliance monitoring effort, and then establish a permanent risk management team to review the risk of major future changes at Florida, she said.
At U S WEST, Mr. Jensen said the fund began formalizing its risk management processes in 1994. As the sophistication of investment strategies grew, policies for monitoring and reporting also grew, he said.
Over time, the fund has adopted a general policy and guidelines for dealing with risk on a total portfolio level, he said.
Bich Pham, vice president in derivatives for T.A.L. Investment Counsel Ltd., Montreal, agrees pension funds and money managers still lag banks, investment banks and corporate treasury operations in risk management.
But pension plan sponsors and the investment management community are catching up, in part because of the explosive growth in the use of derivatives, Mr. Pham said.
Mr. Pham said at least 50% of all trading is done with derivatives, so as a money manager "it's our job to understand what that's about" and to use them to the advantage of their clients.
"Very often these tools (derivatives) are very effective in terms of costs," he said.
Some investors are using more of a rifle approach, hiring consultants to oversee aspects of their portfolios that may be more difficult to monitor.
Richard Pike, president of RP Consulting Group Inc., St. Petersburg, Fla., said that a few years ago he expected his firm's primary business to be setting up investments with futures traders, as it does for the San Diego County Employees' Retirement Association. Instead, RP has seen most of its growth in tracking and monitoring specialized money managers for pension funds and endowments.
Institutions with assets already committed to futures managers, currency overlay managers and hedge fund managers hired RP to help track what the managers are doing with those assets, Mr. Pike said. He declined to name them.
The process at RP can mean real-time tracking of portfolios or enhanced reporting to the plan sponsor. For larger pension funds and money managers, the costs of boosting risk controls are easier to bear. Smaller institutions have fewer resources to devote to the effort and are less likely to be on the cutting edge of risk management.
The typical midsized pension fund heavily dependent on a pension consultant probably trails the most, said Mr. Rawls of Ferrell.
Traditional pension consulting is still focused more on historical returns than trying to identify risks going forward, he said.
For example, there can be just as much hidden risk in a portfolio of small-capitalization stocks as in a portfolio of derivatives positions, he said. Being able to gauge the market risk in all types of portfolios is the key.
One strategy designed to limit market risk at the $1.1 billion Minneapolis Employees Retirement Fund is enhanced portfolios, said Farouki Majeed, investment officer. The idea is to try to keep portfolio returns above a given index with less volatility than the index. For example, a fixed-income manager may neutralize the market return from its portfolio using short positions in fixed-income future, then equitize the remaining "alpha" using long positions in equity index futures.
Other strategies involve constructing long-only portfolios that seek to maximize return and minimize volatility relative to a chosen index. Enhanced portfolios lie somewhere between active and passive management in terms of risk profile.
Enhanced strategies now represent 20% of equities and 60% of fixed income at Minneapolis.
