Risk management is starting to get the critical attention it deserves from pension and other fund executives. This new interest in improved risk management has inspired consultants and others to develop tools, better advice and other services to try to accommodate demand.
But the question for the fund executives is whether these innovative developments enable them to more effectively manage risk and still earn the returns their funds need to meet their obligations.
Many are desperate for help in risk management as they try to meet their return assumptions and recover from the losses suffered in the financial market meltdown in a tough economy.
One of the great strengths of fund executives, especially those at large plans, has been the appreciation of innovation and a willingness to try new strategies and techniques, from indexing in the 1980s and derivatives, private equity and hedge funds in the 1990s to portable alpha and other alternative investments in the current decade.
But this time fund executives should be careful what they wish for, and extra careful what they buy. Risk management is more complex than ever, and many funds haven't yet developed an internal risk management governance structure to set a risk budget, evaluate risk or evaluate new risk tools and techniques. At the same time, the investment management community, with a growing field of risk management to explore, is more developed and sophisticated than ever in terms of marketing and product development.
In the past year, there has been a flood of new indexes that measure some type of investment risk rather than investment return, while new types of risk analytical tools have been developed and more consultants specializing in risk management have emerged.
Over the past year, Russell Investments, teaming with Axioma, has created a series of beta, leverage, liquidity and volatility indexes, each designed to help investors to manage specific types of risk. This month, the two firms jointly introduced a series of factor-based indexes, designed to enable investors to measure a portfolio's relative under- or overweighting against the factors and track factor performance.
In October, Russell teamed with Parametric Portfolio Associates to introduce an index series to measure the level of active risk and alpha potential in a market, and the potential success of active management. The new indexes measure whether stocks are moving together or are diverging, providing an indication of active risk and alpha potential.
Pension fund executives could use the new index series to help with asset allocation decisions, including in which areas to go active and in which to go passive, as well as to evaluate manager performance.
State Street Global Markets in September introduced a series called Turbulence Indices, designed as a broader risk management tool than the CBOE's Volatility Index by providing deeper analyses of standard volatility indicators and measuring correlations between market segments rather than just volatility. They measure market turbulence in seven categories.
In the months ahead, plan executives likely will see the introduction of more tools. But the new risk-related indexes and other tools have yet to be tested for long periods or market cycles. Over time they could prove their mettle, or they could prove to be just another exercise in data mining.
Meanwhile, the best way for plan executives to evaluate them is to step up their own internal risk management, develop a governance structure for oversight and test the new tools carefully on small parts of the portfolios. They have to identify risks, rank them in importance and figure out how to embrace them to achieve their objectives.
While the need for better risk management is critical, if fund executives don't develop a foundation for managing risk they likely will wind up with lots of tools and much advice — but ineffective risk management.