Investors know that market volatilities and correlations can change more quickly than they can change investment allocations. Much has been written about the awakening to the fact that there is risk embedded in all investments. But few have decided how to deal with market turmoil.
For decades, large banks have grappled with the difficult issues surrounding the control and management of financial risks. The goal has been to codify aggregate exposure, limit downside and allocate risk capital broadly and sensibly to improve returns.
Without the expensive analytics and qualified staff to participate in such rigorous activity, institutional investors have traditionally taken a less tactical approach. Diversification into foreign countries, more asset classes and new investment strategies have been the traditional sources of protection for most. Over the past several years, it has become evident that asset diversification has not worked. In this highly connected environment, risks and co-variances can change quickly. Now there are new positions opening at pensions, endowments and foundations with the title, chief risk officer.
Two years after the crash of 2008, requests for proposals seeking risk management are streaming across the Internet. Some institutions want advice and others want to outsource risk management altogether. Three irreversible trends are fueling growth of this new activity.
1. Asset-liability management is forcing institutional investors to focus on absolute returns rather than returns relative to benchmarks. Benchmarks have proven to be potentially unreliable over the short and long run, but liabilities have a way of sticking around.
2. Investors are beginning to realize that asset allocation is a dull knife, and the only way to construct reliable portfolios is to allocate risk. Assets allocated in local currency amounts don't know the difference between Treasury bills and junk bonds. Risk allocation allows investors to diversify risk levels first, and then back into the dollar amounts necessary to fund the risk goals.
3. Risk measurement is evolving, as it should, into risk management. The only thing more frustrating to a chief investment officer watching a portfolio burn is not having any means to put the fire out.
The proper way to consider portfolio and risk management is that one is strategic and the other tactical.
The portfolio is strategically designed to reflect the CIO's vision of where the best risk-adjusted returns can be found. This process is a complex combination of blending all of the pertinent information available to forecast and allocate.
Then there is the ever-changing marketplace and the tactical risk management. First, risk limits are set based on liabilities and the institution's appetite for potentially not meeting required outflows for a given period of time. Once the band of acceptable performance is determined (like guardrails on a mountain road), risk policy may be set to protect the future range of outcomes.
Risk management is designed to bridge the gap between strategic allocations and the time it takes for markets to misbehave. The math gets complicated; the simplest way to think about market risks is to consider the speed of change of market volatility (i.e. allocations made to equities when VIX is at 18 but starts to climb toward 45) and changes in correlations that defeat diversification. Many investment decisions assume the relationship between market and countries will bring diversification value to smooth return streams. If, for instance an investor put an allocation to Brazil to get exposure to soybeans and Russia as a play on oil, the diversification value may be useful, until it is not. Overlays are necessary to bring the portfolio with heavy, correlated exposures back to the original portfolio risk target.
Putting on portfolio overlays is an intense business. It requires the aggregation of market factors that have the greatest impact on price change and thoughtfully selecting the appropriate instruments to use as hedges. The overlays must be carefully managed to stay within the portfolio's guardrails when market turbulence erupts. When markets begin to stabilize, hedges may be removed so the portfolio can benefit from future upside. The original portfolio remains intact, subject to a probable review of risk sensitivities discovered during the turmoil.
Often the lessons learned result in a better focus on allocating risk in the portfolio construction process:
• Risk is not just about limiting downside.
• The result of a good defense is a high return.
• One correlation that is dependable is the correlation between high volatility and declining market prices. By eliminating much of the downside, investors are able to improve returns while maintaining a tight relationship with liabilities.
These are intimidating times. Markets have a lot to be nervous about and no one is surprised at large periodic selloffs. But institutions have projects to fund and pensions to pay. Tactical risk supervision is the best way to ensure long-term strategic growth.