Putting a premium on risk assessment and solutions.
By Ian Castledine
Before the credit crisis, many institutional investors perceived risk as theoretical and risk management as an academic exercise rather than a practical one. But if robust risk management policies had been commonplace, more asset owners would have seen the underlying risks to their portfolios.
The past 18 months have ushered in some of the most treacherous market conditions ever seen. All at once, investors are navigating reduced liquidity, extreme volatility in markets and rapidly changing credit profiles. Investors are realizing that risk management must share equal billing with fund performance.
Implementing an effective risk framework can be a challenge for many institutional investors, be they pension schemes or hedge funds. After all, there is no silver bullet for risk — no one piece of software can ascertain every potential fault line in a portfolio. Add to this the challenges of hiring subject-matter experts and the lead times required to produce meaningful risk assessments, and it isn’t surprising that such analysis goes well beyond the internal resources of many asset owners.
A 2009 Northern Trust survey of institutional asset owners found that 90% of respondents say they don’t have sufficient expertise in risk modeling, including use and interpretation of risk models. Furthermore, only 4% say their organizations have thorough due diligence processes.
A robust risk management policy should provide insight, transparency and objectivity to uncover new layers of risk in an investment plan. Thorough assessment starts with subject-matter experts who provide guidance on the most appropriate models to meet a plan’s unique attributes. And because the sources of risk are constantly evolving, these tools must be integrated to account for changes throughout a portfolio. To do this, best-of-breed risk systems require huge amounts of data covering risk in all its forms — market conditions, credit, liquidity, regulatory and counterparty risks, to name a few.
To truly “manage” risk, however, the vast amounts of data fed into models must be distilled into meaningful information using a robust risk framework that includes the concept of risk budgeting. Such a framework represents a valuable way of incorporating risk and return information in an effort to produce more efficient investment decisions. Integrated tools should provide insights across multiple risk categories, such as dedicated credit models, Value-at-Risk models, stress and scenario tests, and exposure analysis.
Today’s investing complexities demand a strategic, sophisticated and comprehensive approach to risk management. The events of the past 18 months have proven this by exposing gaps in risk processes for all investors except those with the most rigorous of frameworks. For most, the difficulty is accurately identifying risks across financial instruments to understand their portfolios’ true vulnerabilities. Solutions for developing a holistic risk framework do exist and investors employing them are gaining greater insight into their investment plans.