Risk redux: Levels today vary little from those of 2008

Asset owners face the same risk level now as they had in the financial crisis, investment consultants say.

“I really hoped that following the credit crisis and negative experience that asset owners had during that period — and the talk that risk management had to become much more important to avoid these type of outcomes — that (risk) would be much more front and center when talking about asset allocations,” said Patrick Lighaam, managing director in Santa Monica, Calif.-based Wilshire Associates Inc.'s consulting unit.

“But it is not something, at least across the board, that we have seen,” Mr. Lighaam said. “There are some very small exceptions. But again mostly ... risk is the outcome rather than the input in the decision-making process.”

“In general (today) vs. 2008, institutional risk postures are similar,” said Christopher A. Moore, chief investment officer with Summit Strategies Group, St. Louis. “Immediately following 2008, we saw aggregate derisking ... selling higher-risk ... equity allocations for more diversifying assets.”

Since then, there have been “offsetting moves to stretch for return ... (with investors) creeping out the risk spectrum of increased allocations to illiquid assets, such as private equity. Net-net, in aggregate, I would say there are similar risk postures today” as 2008.

Asset owners should make risk a “primary input” of their decision-making on investment policy and asset allocation, a priority that has been elusive for many fiduciaries even almost a decade since the start of the financial crisis, said William F. Jarvis, executive director, Commonfund Institute, the education, research and investment consulting arm of Commonfund, both based in Wilton, Conn., echoing sentiments of other investment consultants.

“In 10 years-plus experience ... of reviewing investment policy statements ... they almost always were not specific about risk,” Mr. Jarvis said.

“Most investment policy statements are specific about returns being sought,” Mr. Jarvis added. “They will set out an asset allocation policy portfolio, which is intended to achieve that result. Then there will be a section or maybe just a sentence about risk.”

A “risk-first approach implies and requires actually a discussion about which risks are the ones potentially most harmful to the institution,” he said.

Such an approach “won't necessarily get you a higher expected return, but it will make you much more knowledgeable about the sources of return that you are getting,” Mr. Jarvis said.

Risk tools and modeling power are “rather commonplace” now, he said, and asked: “Why would you not want to use these tools to create a set of ranges within which a board and investment committee say they are comfortable to live?”

If the actual returns from the expected portfolio fall short, “that doesn't mean you failed. It simply means you have to dialog about which risk level is appropriate to get the return you feel you need, or whether you really ... are going to have to accept this lower level of return,” Mr. Jarvis said.

A risk-first approach might be more complex, Mr. Jarvis said, “But I could also say that the traditional way of constructing portfolios is inappropriately simple. What we are doing here is calling into the light something that has been there.”

“Putting risk first ... implies and requires actually a discussion about which risks are the ones potentially most harmful to the (asset owner),” Mr. Jarvis said. “When, for example, last year's China market declined, a properly informed fiduciary, even if they are not a financial specialist, would be able to say, "We understood this was something possible ... and this was still the right portfolio structure and we did accept that risk.'”

“That enables the fiduciary to more fully inhabit their role,” Mr. Jarvis said. Instead of becoming a “blame game” with investment managers there is “a mature ownership of that balance between the risk that is being accepted and the return that is being sought.”

“This kind of modeling, if it is properly implemented, enables a more dispassionate analysis of what the portfolio would consist of and can really help an investment committee chair or a board chair to strip away some of the behavioral biases that may exist even in a well-informed group of fiduciaries or asset owners,” Mr. Jarvis said.

“There is no portfolio that can give you the return you want while protecting you for every risk that you want to be protected from,” he said.

“Governance related, your asset allocation is the most important decision to make and it drives the majority of your risk and return,” Wilshire's Mr. Lighaam said. But “a lot of people in this industry are still guilty of spending a lot more time on manager selection and all kinds of smaller impact decisions, partly because it is so much easier (discussing) whether you like a manager or not.”

But “it's much more important to look at the bigger picture and to have five meetings a year about asset allocation and risk, and maybe one meeting about managers.”

“Risk is not easy,” Mr. Lighaam said.

“It's very easy for me to say, "Oh, just buy a risk management system and this will help you get a perfect risk management approach,'” Mr. Lighaam said. “Unfortunately, a risk system is not going to educate boards. A risk system is not going to tell you how to have these governance-related discussions.”

“The risk system by itself is never going to give you the outcome of having a risk-focused investment approach that you would like to have,” Mr. Lighaam said. “You need to have a very high and strong focus on education, on discussions making sure this is the topic you talk about” at most meetings.

Asset owners “need to have a more fundamental discussion about what their objectives are and what level of risk they want to achieve these specific objectives,” Mr. Lighaam said.

“Diversification gets you part of the way, and that is always one of the most important things for asset owners to consider,” Mr. Lighaam said. ”But there is only so much (risk mitigation) you can get from diversification. ... You've seen some plans talking about growth portfolios and stability portfolios. That is a good step forward to have a more holistic view about your allocations.”

For example, Mr. Lighaam said. “If my old risk was 10% and I want to be less risky and now I'm going to 9.6%, I (have) less risk.”

But in a 2008-type of crisis, he said, that would mean funds would only drop 19% or 18.5% rather than 20%. “That's still a very undesirable outcome,” he said.

Asset owners “are looking at risk. But they are very much looking at from the point where they currently are, rather than looking at it from the point, 'How much can I bear in a drawdown scare such as 2008?'” Mr. Lighaam said.

“Ultimately, what I want to see in risk management is being prepared for the different adverse scenarios that might occur and make sure you are prepared to actually deal with these situations or even better, actually be prepared to take advantage of these situations. ... That is the best outcome. That is the moment where risk management is not only going to give you protection on the downside but it also is going to give you the potential upside because of the distress of others. That is the moment where you can really turn risk management into a profit center.” n