Value at risk and other risk management techniques might change the way institutional assets are managed, giving investors better access to information on how portfolios behave.
Once viewed as a means of policing portfolios, the high-level statistical calculations that have sprung from risk management are giving investment managers and tax-exempt investors the firepower to make better informed decisions.
Although risk management technology is still being adapted to the long-term investment world, the opportunity for investors to improve their ability to manage risk and return continues to grow.
The use of value at risk, often called VAR, as a risk management tool is popping up among the different types of participants in the tax-exempt investment process.
Institutional investors such as the Ontario Teachers' Pension Plan Board, North York, Ontario; Harvard Management Co. Inc., Boston; and OppenheimerFunds Inc., New York, already use value at risk in managing their assets.
Basically, value at risk is a statistical attempt to identify the maximum amount a given portfolio or portfolios will lose over a set time period, and with a given confidence level
For example, a $100 million portfolio of U.S. equities might have a value at risk of $3 million over a coming week, with a 95% degree of confidence. VAR generally does not try to capture unusual events, and in those circumstances the losses could be much greater.
Experts caution against relying too much on VAR, saying despite its strength as a risk gauge, it can be misleading as well.
Nevertheless, industry participants agree VAR can be effective for all types of investors, even though its roots come from a trading type of environment.
"The basic concept of value at risk makes sense," said Scott Lummer, managing director for Ibbotson Associates, Chicago. For example, it takes into account the true leverage of an instrument, such as a futures contract, combined with the volatility, he said.
The merits of value at risk come from its ability to combine exposures to different interest rates and different securities, he said.
A commodity futures contract position will have much more volatility than a U.S. Treasury bond futures position, and VAR takes that into account, Mr. Lummer said.
VAR methods can combine different security types by looking at historical security correlations and volatility under different market scenarios.
"Value at risk is an important risk tool," said Russell Read, vice president and portfolio manager for OppenheimerFunds.
"VAR has been used by the investment dealer community for several years, but is relatively new to the investment management side," he said.
Previously risk was viewed one-dimensionally, such as within the scope of how a portfolio would be expected to react to a change in interest rates. Value at risk originated in the broker-dealer and banking world as a means for trading operations to total up the amount it could lose within a specified confidence level.
For example, Bank XYZ might have a significant exposure to a multitude of currency and interest rate markets, that in total appear quite risky. But after taking into account the ways in which the securities act similarly or differently, using VAR, the expected market risk is much less.
Risk across the portfolio
For pension funds and money managers, that means market risk can be totaled across an entire portfolio to come up with a comparative number for how risky the portfolio is.
The Ontario Teachers' Pension Plan Board, with C$53 billion ($38 billion U.S.) under management, uses value at risk in a number of ways, said Leo de Bever, vice president of research and economics.
The Ontario Teachers' plan implemented a system from Reuters' Sailfish Systems to measure the fund's short-term risk in its asset mix and to measure the risk managers are taking relative to benchmarks. The pension plan also is beginning to use the system in creating risk guidelines for its managers, he said.
Value at risk is giving the fund more flexibility, and may allow the fund to take on more risk and achieve better risk-adjusted returns, Mr. de Bever said.
Having a better handle on market risk will allow managers to selectively take on more risk, when it's appropriate, he said.
Detailed investment guidelines may no longer be necessary, he added. VAR-based limitations within broader restrictions are selectively being added to the fund, he said.
The problem with detailed investment restrictions is they can't easily take into account all aspects of risk in a security, such as leverage or correlation, Mr. de Bever said. So within some broader investment guidelines, Ontario's investment managers might find a value at risk limitation will allow them to be more aggressive within the existing mandate of the fund, he said.
Harvard Management Co., which manages Harvard University's $11 billion endowment fund, has used value at risk for about one and a half years, said Verne O. Sedlacek, executive vice president and chief financial officer.
"We have found it a very effective tool," Mr. Sedlacek said, speaking before schools that invest with The Common Fund, Westport, Conn., at a conference in Chicago.
Harvard Management developed its value at risk methodology internally. Harvard calculates VAR monthly on its various asset classes, and presents it to the board on a monthly basis, he said.
It calculates absolute value at risk, and VAR relative to chosen benchmarks, which gets much of the focus, Mr. Sedlacek said.
A graphical representation of how its relative value at risk changes at the asset class level is a particularly useful report, he said.
And Harvard staff members did a test to see how well its VAR calculations were being computed.
"We were pretty relieved (that) it seems to be picking up our risk," he said.
Improving job performance
At Oppenheimer, VAR is being used to try to increase the company's risk-adjusted performance, and help portfolio managers do a better job, which Mr. Read believes is an unusual application.
"The productive use of risk to help managers identify and be compensated for taking risk is something new" for investment management, he said.
He said risk management is changing from a staff function, such as accounting, to a line function alongside investment managers.
VAR can be calculated in different ways, which can produce results that vary with the type of investor and the time horizon the investor wants to look at.
Robert Baldoni, partner within the risk management and regulatory practice of Ernst & Young L.L.P., New York, said the usefulness of value at risk lies in its ability to measure risk across asset classes.
But identifying the risks is important. "The key to success is risk measurement," he said. Once risk has been measured, then pension plan sponsors can set up policies and procedures and perform advanced risk analyses.
VAR information can be applied in different ways.
Amir Sheikh, director of risk management services for consulting firm BARRA, Berkeley, Calif., sees increased demand for VAR-based analysis coming with increased use of complicated derivatives. However, he said existing risk methodologies work well on most types of securities, and VAR wouldn't be needed in those situations.
Asset allocation use
Lisa K. Polsky, managing director with Morgan Stanley & Co. Inc., New York, said one interesting use for VAR is to more actively manage a fund's target asset allocation. The major inputs that go into an asset allocation model can vary over time, although the models assume they don't, Ms. Polsky said.
"Your asset allocation may be changing and you don't actually know it," Ms. Polsky said.
So while volatility and correlations will change, asset allocations generally won't take that into account, she said.
VAR could allow plan sponsors to manage their target asset allocation more closely as security correlations and volatilities change.
"If your expected returns aren't changing, but risk is increasing . . . shouldn't you (adjust) your investments?" she said.
Options would be a way to manage asset allocations as volatilities and correlations change under a value at risk methodology.
If correlations are rising among a given asset class, a put option could be used to reduce the resultant increase in market exposure, she said.
One downside is getting a fund's security data into one spot: "It's hard, hard, hard," she said.
New role for custodians
Because data assembly is so difficult, pension custodians increasingly are being viewed as partners in the risk management process.
Custodians have all of the data, so they appear to be the most logical place for risk management to begin, said Elisa K. Spain, senior vice president in strategic product development with The Northern Trust Co., Chicago.
As a result, "it seems like there is huge demand" for value at risk services from custodians, she said.
A very relevant way to use VAR would be for quarter-over-quarter comparisons, Ms. Spain said. If VAR is increasing or decreasing over time, a plan sponsor will be able to use that information to reevaluate what it or its managers are doing.
But Ms. Spain said VAR isn't a tool to "micro-manage" investment managers. It instead can be used to open up investment possibilities, as market risk and exposures become more transparent.
After becoming comfortable with a fund's VAR and how different asset classes interact, a pension plan manager might be more inclined to add market exposures previously viewed as too risky.
That could open the door to, say, emerging markets or a derivatives-based strategy, which can be modeled with VAR.
While Northern doesn't offer value-at-risk services now, it is close to doing so and has a system that is going into the initial testing phase, she said.
Some say VAR can be used for tracking investment managers as well. Value at risk is "a more elegant and more incisive way" to tell if your managers are taking risk the way they're supposed to, said Michelle McCarthy, managing director for Bankers Trust Co., New York.
"It has a lot of appeal," she said.
Plan sponsors won't be as easily fooled by a change in a name of a security, or by a security that might sound innocuous but is really quite volatile. Bankers Trust provides VAR-based services through its RAROC 2020 product.
But with the advancements in using value at risk comes concern its limitations will be forgotten.
"It's a solid framework to view risk, but it depends on what you do with it," Ibbotson's Mr. Lummer said.
If some of the assumptions that go into a VAR model are wrong, then the number itself will be wrong as well.
"People tend to underestimate the risk of real estate and venture capital, because they're not marked to market," Mr. Lummer said. While he's not predicting problems, those are the types of areas where VAR systems could slip, he said.
And as with any assumption-based model, what has happened in the past won't necessarily hold in the future. "Records were made to be broken," he said.
Edgar Peters, director-asset allocation for money manager PanAgora Asset Management, Boston, said he advocates value at risk, but also underscored some of its shortcomings. He said techniques often use statistical assumptions that turn out to be wrong. "There are limits to what quantitative methods will tell you."