Return and risk are the two fundamental components of investment management, and they are inextricably tied together. The higher is the expected return, the higher is the risk.
But you would never guess the equal importance of the two components from reading investment policy statements at many pension funds. Generally there is a lot of discussion of the return side of portfolio investing, but little about the reality of risk and its management.
That absence helps to explain why so many pension and other fund executives were surprised by unanticipated risks in the markets generally, and especially in certain asset classes, risks they thought would be mitigated by diversification and monitored by volatility.
Fund executives need to beef up their risk management practices. They have paid a price for giving insufficient attention to risk management as their assets were devastated, and funding jeopardized, by the market collapse and the weak economy.
Fund executives can't eliminate risk. In fact, they must embrace it in order to achieve the expected returns they need to fulfill their investment objectives. But they need to more carefully manage risk, and to do that they must adopt a new attitude toward risk, and new management practices.
They can't embrace risk management unless it is a foundational part of the investment policy statement.
Many fund executives need an education on what risk really is. Risk management is more than volatility, tracking error and value at risk, and controlling risk involves more than diversification.
Just as fund executives develop an asset allocation plan as part of an investment policy statement, so should they develop a risk budget, which gives a risk-exposure context to asset allocation.
The State of Wisconsin Investment Board noted in a report last December that its core fund allocation, “while being reasonably diversified,” including 55% to equities, “is disproportionately exposed to equity risk,” with equities contributing 90% of total volatility.
The policy statement should identify who oversees risk management. Logically there should be a chief risk officer as counterpart to a chief investment officer.
Fund officials might consider adding specialty consultants in risk management. These consultants should have deep expertise in the types of risks to which funds are exposed, and the way managers and other investment-related firms identify, measure and manage risk. Investment consultant expertise doesn't necessarily extend to a thorough expertise in risk management.
The Illinois State Universities Retirement System's current search for an investment consultant for the first time includes in its RFP an assessment of risk management capabilities and costs.
The California Public Employees' Retirement System last year created an ad hoc committee on risk to take a comprehensive examination of risk and on Sept. 15 created the position of chief risk officer and office of enterprise risk management.
The Florida Board of Administration created the position of chief risk and compliance office last year. Boeing Co., whose 20-member investment staff includes five devoted to risk management of its $73.3 billion in retirement assets, and the Alaska Permanent Fund Corp., whose investment policy statement details risk management oversight for its $35.6 billion in assets, could serve as models for funds seeking to strengthen risk management.
Fund executives, by making risk management fully part of an investment policy statement, will bring more intellectual rigor to the process of evaluating and setting policies on risk management, and that, in turn, should result in better oversight and greater likelihood of meeting investment return objectives.