SAN ANTONIO - Remember risk management?
When last heard from, risk managers were extolling the virtues of value at risk and risk budgeting to plan sponsors whose index fund investments were generating 25% annualized returns.
They tried talking about derivatives, too, but plan sponsors didn't want to hear about futures or options that protected against downside risk when there didn't appear to be a downside anymore.
Now the shoe is on the other foot, as it were; or perhaps the fat tail is just on the other side of the curve.
Diane M. Garnick, chief U.S. portfolio strategist for Dresdner Bank AG, New York, called the radical shift from the steady upward positive returns in the late 1990s to what we see today "a tale of two tails."
Throughout 2002 and into this year, lackluster returns and extreme volatility have combined to focus renewed interest on measuring and managing risk. Pension funds are getting hit from both sides. Falling stock prices have caused losses in their equity portfolios, while falling interest rates have increased the present value of their future benefit liabilities.
Risk managers are responding to the shift in plan sponsor fortunes in two ways: They are reminding institutional investors of already available methods for measuring and controlling risk, and they are developing new methods.
For instance, new risk models are more sensitive to what Joanne M. Hill, managing director of global derivatives and trading research at Goldman Sachs & Co., New York, called asymmetric risk. This takes into account that investment returns are almost never truly normally distributed, like most models show. There is usually a fatter tail, or a greater occurrence of abnormal returns, on one side than the other. The trick is watching for signs that the fat tail is shifting.
Ms. Hill said pension fund executives have been thinking more recently about strategic asset allocation and getting more return for the amount of risk they're taking. Market volatility has stung them, mostly because all the volatility seems to be on the downside these days.
Strategies for improving total portfolio returns when equity returns are lower and more volatile include increasing weights on active bets, adding weight to alternative investments, and keeping equity weights as high as possible but hedging against declines by using derivative strategies.
"Pension fund priorities are now to find alpha," Ms. Hill said. "Index derivatives can help enhance returns in a moderate equity return environment."
There is also greater interest today in measuring corporate credit risk and applying that data to portfolio management.
Options volume among institutional investors is picking up, as portfolio managers use options to hedge against individual equity and equity index volatility.
New products such as an investible equity index option benchmark are on the horizon. So are narrow-based stock index futures, which will allow investors to buy futures on baskets of stocks in industry sectors like biotech, defense and gold mining.
At least one corporate pension fund even abandoned its "long-term investor" view of the world in late 2002 to put on a three-month hedge, using options to lock in equity gains and avoid making a contribution to its defined benefit plan, said Jeff Nipp, head of investment manager research at Watson Wyatt Investment Consulting, Atlanta. He wouldn't identify the plan.
Useful new tools
Many of these new tools will be useful, said Mark Abbott, managing director of investments at Guardian Life Insurance Co. of America, New York.
"Looking at asymmetric risk is a critical change in risk management," Mr. Abbott said. "We have to have better measuring tools to keep track of volatility. These sorts of innovations are good because having more than one source of information allows you to weigh them."
John Ravalli, head of investment risk management at Fiduciary Trust Co., New York, said risk management systems aren't getting smarter, investors are.
"We don't get an RFP anymore where they don't ask about our risk system," Mr. Ravalli said.
Risk measurement systems only show where risk might be, and even then many still aren't good at giving investors a clear picture of their aggregate risk across all asset classes.
"We find it hard to aggregate the risk of a hedge fund investment in a portfolio of stocks and bonds," Mr. Ravalli said. "That's related to not having enough information from the hedge fund. It's a transparency issue."
"Once you understand how to measure risk, you're more apt to have a higher tolerance for risk" and hopefully get a better return for the portfolio, Mr. Ravalli said.
Ronald M. Egalka, president and chief executive of Rampart Investment Management Co. Inc., Boston, said he thinks pension funds can use derivatives such as a new buy-write option benchmark to achieve higher returns with lower risk. This is the first such benchmark, designed to track an option strategy on the Standard & Poor's 500 by continuously rolling over one-month calls on the index.
The Chicago Board Options Exchange introduced the benchmark, called the BXM, and officials there have filed for patent protection. Recently they gave Mr. Egalka's firm an exclusive license to develop an investment product based on it.
Mr. Egalka said the BXM outperformed the S&P 500 on an annualized basis by more than 10.5 percentage points over the trailing three years, with 25% less risk. Over the past five years, the BXM outperformed the S&P 500 by an annualized 5.5 percentage points, again with one-quarter of the risk.
The lower risk is the key for plan sponsors, he said, more so than the outperformance of the underlying index.
Randall L. Kirkland, managing director and senior consultant at Asset Consulting Group Inc., St. Louis, said conserving principal and avoiding big losses are more important today than ever for plan sponsors. And yet many are still reluctant to embrace derivatives in risk management.
Speaking at a risk management conference in San Antonio last week, he said: "If I had one wish, it would be that the defined benefit plan sponsor community would be filling this place, listening to what you (risk managers) have to say. They need to hear it."
David M. Blitzer, managing director and chairman of Standard & Poor's Index Committee, New York, said risk management has all the tools it needs. The problem has been the people. The exuberance of the late 1990s led to a lack of foresight, he said.
"The real limit (to risk management's effectiveness) is the human side of risk management," Mr. Blitzer said. "We have to tell ourselves `the bull market is over; it's a new game.' The hard part of risk management is recognizing the need to do it and having the wherewithal to go out and do it."