Investors’ changing views on risk management open the door to more dynamic portfolio strategies.
By Andrew C. Smith, CFA, CAIA
In the post-financial crisis world, the vocabulary used to discuss risk has changed. While institutional investors have always been “risk aware,” the attention given risk management traditionally has been a step below their focus on returns. In other words, it was previously viewed as a necessary, but secondary, task.
In the not-too-distant past, risk assessment was often performed as a confirmation of managers’ returns, with the discussion oriented toward market risks. However, in the current environment, a plethora of additional risks have entered our consciousness — liquidity risk, counterparty risk, concentration and fraud risk. Indeed, our vocabulary of primary risks that need to be managed, and the emphasis now placed on risk management, is increasing.
Today, risk management is on equal footing with return generation, as chief investment officers (CIOs) are ever mindful of their dual mandate to produce returns and manage risks. This is in sharp contrast to the traditional risk-management approach, which took more of a “reporting,” rearward-looking approach without much qualitative analysis or discussion around risk appropriateness.
Yet, as CIOs pursue their dual mandates, they often encounter the limitations of their internal risk-management tools and resources, as well as the potentially debilitating impact of poor risk transparency on sound strategic planning and investment decisions.
The shift in risk-management approaches — from reporting on risk to anticipating and managing risk — is definitely cultural. A proactive and forward-looking approach to managing risk, with an appropriate focus on monitoring risk, can be liberating. Good risk management offers the possibility of emerging from the herd, of breaking free of the constraints of the style box, and investing with purpose to achieve long-term portfolio objectives.
The truth is, all but the largest investors are poorly equipped to do this. They lack internal data, tools and staff. An intriguing solution would be to hire a “risk manager” to provide the tools, staff and expertise required for the CIO and board to have an ongoing cross sectional view of risks. Reporting to either the CIO or the board, the risk manager can provide an unbiased view of risk, independent of money managers and consultants, combined with forward-looking stress tests and scenario analysis across all asset classes and strategies.
When risks are poorly understood or measured, it’s an obstacle to dynamic portfolio management. Risk management must be a proactive exercise, not a reactive one, and that requires changing risk management processes from a reporting function into a key management function.