Pension funds and other institutional investors must step up transformation of their risk management to make it a real partner in the investment-decision process to reduce the risk of losses from the type of unprecedented asset meltdown of the financial market crisis, according to a new study McKinsey & Co. expects to release later this week.
Past efforts by institutions to strengthen risk management, such as after the 2000-2001 high-tech bubble, failed to keep up with evolving financial markets, wrote the three McKinsey analysts who authored the study, “After Black Swans and Red Ink: How Institutional Investors Can Rethink Risk Management.”
The huge losses by pension funds and other institutional investors in 2008-2009 exposed the inadequacy of those earlier efforts, including their underestimation of risks — from investment processes to risk measurement systems that fail to capture all possible problems, the authors wrote.
Many institutional investors “realized that their risk management approach significantly lags the investment capabilities they had developed over the past decade,” wrote the three authors: Leo Grepin, a New York-based director, and Jonathan Tetrault, a partner, and Greg Vainberg, a consultant, both based in Montreal.
Strengthening risk management includes a need to build better stress testing on the impact of extreme market events as well as identifying emerging risks and their impact on the portfolio, Mr. Tetrault said in an interview.
“I'm not sure it will make (institutions) more risk averse,” he said. “They still have to generate return to meet their expected rate of return to meet liabilities. It will allow them to optimize use of risk budgets. It will help them become more resilient and optimize risk-adjusted return.”
“Depending on their appetite for risk, the better they understand their risk exposures, the better they will be at taking advantage of risk opportunities they can manage,” Mr. Tetrault added.
In the report, the authors estimated that in 2008-2009, pension and sovereign wealth funds alone lost $500 billion.
“In almost all cases, these losses were well beyond the maximum foreseen by institutions' value-at-risk calculations and stress-testing analyses,” they wrote.