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Risk is not a four-letter word

The evolution of risk management has been a long, often painful experience for many investment plan sponsors.

The evolution of risk management has been a long, often painful experience for many investment plan sponsors. But risk doesn’t have to be a four-letter word. In fact, in case you haven’t noticed, there’s currently a revolution going on in our industry. Most mega-funds (those in excess of $10 billion) have already made the move to a more comprehensive approach to enterprise risk management. Now smaller funds are contemplating how to respond to keep pace.

First, a brief history lesson. Risk management has had three noticeable periods of development: Acceptance, when risk was largely ignored (pre- 2000); Acknowledgement, when plan sponsors discovered the real meaning of risk (2000-2008); and Action, which has resulted in a risk revolution (2009-present).

Before 2000, Modern Portfolio Theory was firmly entrenched but not as well-understood by practitioners, whose focus was on optimizing return. Standard deviation and correlation were the key measures of risk. Yes, most funds used A/L modeling and some Monte Carlo theory, but sponsors focused on their assets (not the liabilities)—on the average forecasted return, and perhaps anticipating a one, or at most a two, standard deviation event. Tail events were largely ignored, with most additional effort into adding value through active management. Capital markets were nevertheless favorable, and diversification meant simply expanding a portfolio into foreign markets.

In short, the crux of the problem was the inequitable amount of time and resources that investors spent on return over risk!

The wake-up calls came between 2000 and 2008, when returns moved back towards their historical average and investment funds shuddered under the Tech Wreck, the Global Financial Crisis and the European Debt Crisis. Investors had few places to avoid the market downdraft other than government bonds and gold. Standard deviation and correlation were fully exposed as unstable and of limited value in a stressed environment.

In fairness, some funds, after the first calamity, tried to diversify into alternatives (hedge funds, private equity, etc.), but usually forgot about three deadly portfolio sins: leverage, illiquidity and the lack of transparency in many derivative products. Only a few mega funds escaped the onslaught by successfully recognizing risk, and lengthening or increasing their fixed income investments to more closely match their liabilities.

It was then, as our economic system teetered on the brink, that the majority recognized the benefits of risk management—that market risk isn’t stable over time, and tolerances are subject to dramatic change. Trying to solve the risk riddle with a simple, two-dimensional (mean/variance) optimization tool designed for normal markets just wouldn’t work. There was a need to make tradeoffs and to evaluate the multi-dimensionality of risk. And, for that, better tools and insights would be necessary. Luckily, there were advances in computers, and investors admitted their foibles while acknowledging their limitations.

Since 2008, there has been a plethora of books on risk management, but their dominant theme was that good policies and effective fund governance are intricately intertwined, and that risk requires various diagnostics. Deficiencies in risk management and distorted incentive systems clearly pointed to poor board oversight. More recently, regulators have entered the fray and see risk policy as the primary duty of the board in any organization. So investment funds and most companies have seen the light, and a risk management revolution has begun.

What does it all add up to? Fiduciaries need to adopt better, more prudent processes and to consider the impact of human behaviour on investment decision-making. But this means an entirely new approach. We’re not talking about structural tweaks, but a better framework and culture. This is why we’re seeing a total transformation in our industry as a more comprehensive approach takes hold, including ERM. The mega-funds are already committed to this approach, but how will smaller funds, which lack scale and resources, make that successful transition?

Copyright 2014 Rogers Publishing Ltd. This article first appeared in the August 2014 edition of Corporate Risk Canada magazine

Copyright © 2016 Transcontinental Media G.P.
Transcontinental Media G.P.