As a prominent attorney put it the other day, “GRC” is the only topic on the mind of investor trustees these days — Governance, Risk and Compliance. So many pension plans are underfunded the trustees need to make sure there are no slips or cracks in their investment process. Not knowing what your portfolios' risks are or how those risks can potentially threaten performance is no longer tolerable. As the chair of a pension plan for police and firefighters said at an institutional investor conference, “My constituents were mad as hell when we lost our shirts in '08 — I can't afford to lose their money again — they carry guns and axes!” And even though the SEC has created its own monster by demanding more paperwork than it has manpower to review, compliance with Dodd-Frank is consuming investor and manager time.
Technology is raising the curtain on risk
How to manage portfolios in this brave new world where the pace of change is always accelerating
Managing investment risk is no longer optional. It is a fiduciary obligation.
Of the three main issues, governance and compliance have precise rules and steps to follow. The risk issue has no definitive guidelines. As most of us know, the only risk that matters is the risk of not meeting obligations — for any reason. Liabilities, being streams of cash flows, force investors to worry about absolute levels of risk and return. Any untrustworthy benchmark must be either avoided or managed carefully.
Risk in all forms cannot be accurately measured. As my late friend Peter Bernstein accurately assessed in “Against the Gods,” man has been trying to narrow the range of risk in every pursuit since the beginning of time, and is no less focused today. Where persons or governments intentionally cover up their intentions to inflict harm on other people or cultures, they can often pose great risk threats. But while these well-hidden terrorists are hard to anticipate, the great majority of risks are in full view if we use technology to collect and measure them. Some are tough to convert but the “new normal” is a world armed with the biggest blow ever to secrets, the Internet.
So if information is instantaneous, how do we deal with the volume? In many fields outside our comprehension and field of expertise, we don't. But investors enjoy the benefit of a global translator — the markets. Markets reflect millions of attitudes, sentiments and biases. Everything is mathematically represented by price. And all prices are relative. Prices change at different speeds. And like everything else, each day is different.
This then takes us to the institutional investment process. Traditionally, portfolios were constructed through an asset allocation process. Asset allocation models would take the available investment strategies and allocate sums of cash to each according to estimates of future return and value of diversification. Based on the best available information at the time, the investments were made and then results reviewed quarterly. This outdated methodology has three basic major shortcomings.
1) Asset allocation does not know the difference between Treasury bills and junk bonds. This will not change because a measure of assets is simply a value of money with no regard for how the money is employed.
2) There used to be diversification value in investing across global markets. But according to Peter Christoffersen at the University of Toronto, the correlations across 16 developed countries' equity markets have migrated all the way from 0.25 in 1997 to 0.8 today. It is hard to maintain liquidity and diversify portfolios with conventional long-only investing.
3) All assumptions regarding risk, potential return and correlation change often and, in many instances, dramatically. You can see change coming, but doing anything proactive to protect assets in times of market turmoil requires infrastructure, discipline and sound judgment.
The portfolio that a well-intended CIO constructed might be ravaged by turmoil in the global financial markets, and results can be painful. As I asked a CIO at the end of 2008, “When the VIX soared to 70, you knew your portfolio risk was at unprecedented heights — did you believe that you were getting ready to make a lot of money?” History shows many variables, including the unpredictability of returns, but there is no question that market risk can be spotted on the horizon, if you know where to look and ask the right questions.
We have laid the foundation for some answers, and the good news is they are available. The information explosion brought to us by the Internet offers many benefits.
As Matt Ridley points out in his recent book, “The Rational Optimist,” ideas in today's world mate with one another producing better generations of ideas. Silos are crumbling as cross-pollination of best practices merge the sciences. We are not just better off in terms of global lifestyles, but much safer from disease, death by automobile, and better prepared to face more predictable changes in everything from the weather to traffic jams.
The silos of ideas in each scientific pursuit cross-fertilize at an amazing pace. Every day brings more people into the process, each with a new way of looking at and trying to solve a problem. In the technological world the pace of change is accelerating; it will in the investment realm as well. Mr. Ridley's silo mating can be applied to the convergence of investment management and trading management. Long-term investments need short term tactical protection when the strategic assumptions change.
The risk measurement tools that software developers have been selling to trading operations at big banks and hedge funds are now finding their way to pensions and endowments.
The first step in building the foundation for the new model of investing is the real time availability of clean, accurate information. Today, custodians, administrators, and market makers store and report record volumes of information. There is no longer any excuse for not knowing granular detail about an investment portfolio.
The second step is that information can be transformed into insight — provided by software that analyzes thousands of portfolio investments and prices from global markets. Many of these are attached to “risk engines” that help evaluate the relative temperatures of investments and the expected range of outcomes, or chance of fire, as the case may be.
The third step relates to investing in the impact layer of risk management. Controlling risk depends on skill, experience and judgment. Investors would love to have an algorithm capable of evaluating an investment portfolio and then pumping out the perfect risk containment solution. Life would be much simpler (except for me, since I would be out of work).
The key elements of managing risk effectively revolve around the speed of change in volatilities, co-variances, liquidity, and credit. The path dependency of hedging relies on the nature of the issues and the menu of currently available alternatives that will most effectively reduce downside exposure.
The best way to manage a portfolio using today's technology includes the following:
c Allocate risk to the investment strategies you believe likely to provide coverage of liabilities, and depending on where you stand in funding, will provide the level of stability that allows trustees to sleep at night. Then back in to the amount of currency it takes to accomplish your risk allocations.
c Connect your sources of investment information to market information. Set risk policy limits that will give performance an acceptable range of outcomes for your goals set in Stage I. The combined application of a GARCH model and risk engine, capable of providing ongoing evaluation of the changes in volatilities and their correlations, can be helpful in making a refined forecast. Then aggregate risk into portfolio replicators or “key drivers” to provide manageable proxies.
c Hire internal staff or a competent risk management firm to provide the infrastructure to manage the process. The result will be that you will have trading accounts that will enable them to hedge any key components of your portfolio that misbehave, or overlay the portfolio itself if necessary to anticipate and avoid tail losses from excessive market dislocations. Just be sure to hire professionals who worry about the right things. Managing overlays in volatile markets requires a lot of experience and a specialized skill set. If you find that your portfolio is requiring constant or frequent hedging, you will need to find the cause and reconsider the risk allocations.
In any case, risk management should be part of a continual process to help your investment program survive with the fittest. “GRC” is important because it should be. Pensioners, universities and grant recipients expect better care of their future. Cross-pollinating the best attributes of long-term strategic investment management and trading management will result in improved performance. The best available tools and ideas combine technology with competence to improve the quality of the investment committee process and the peace of mind of trustees.