Principles of Buy-Side Risk Management

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1 Principles of Buy-Side Risk Management Bennett W. Golub, PhD Chief Risk Officer June 16, 2014

2 Table of Contents Principles of Risk Management I. Risk Management Requires Institutional Buy-In II. Institutional Interests Need to be Aligned III. Be a Risk Taker But Think Like a Risk Manager IV. Risk Management Organizations Need to be Independent V. Define Your Fiduciary Responsibilities VI. Bottom-Up Portfolio Risk Management VII. Risk Models Require Constant Vigilance and Skepticism VIII.Risk Management Does Not Mean Risk Avoidance 2

3 Principles of Risk Management For an asset manager, Risk Management is a set of techniques and processes that can be used to help ensure that: Portfolios meet the reasonable expectations of the client. As a result, we seek to make sure portfolio risks are: Deliberate, Diversified, and Scaled. While an increasing portion of risk management is required by regulators, BlackRock believes that: Good Risk Management is Good for Business. 3

4 Principle 1: Risk Management Requires Institutional Buy-In Risk Management Requires Institutional Buy-In: The right tone from the top is essential for risk management to really work. o Will senior management support risk managers publicly and behind closed doors when making tough calls? Comprehensive risk management policies need to be established and implemented. o Senior management has to articulate its commitment to and enforce clear policies on the roles of risk management. Good risk management is EXPENSIVE requiring significant human and technological resources. o Prioritizing risk management comes at some sacrifice to other priorities. 4

5 Principle 2: Institutional Interests Need to be Aligned Institutional Interests Need to be Aligned: Whose risk is being managed? Risk management can be most effective when an entire institution pulls in the same direction. o Shared interests allow risk management to focus primarily on executing and protecting common objectives. Common objectives are difficult to maintain when there are multiple non-aligned constituencies within a firm. o This type of environment requires risk managers to take on more of a policing role, to protect common objectives. Risk Management Institution 5

Principle 3: Be a Risk Taker But Think Like a Risk

Ideally, risk managers with subject-matter expertise

managers to help ensure that the portfolio management

Experience shows that for asset managers, a risk

6 Principle 3: Be a Risk Taker But Think Like a Risk Manager Be a Risk Taker But Think Like a Risk Manager: Ideally, risk managers with subject-matter expertise can work collaboratively and closely with portfolio managers to help ensure that the portfolio management process is risk aware. Experience shows that for asset managers, a risk consulting approach works better than the institutional policeman approach. We strive for the Lazy Risk Manager Approach to Risk Management: o If risk takers think like risk managers, most risk problems go away. 6

Principle 4: Risk Management Organizations Need to be Independent Risk Management Organizations Need to be Independent: To be able to say what needs to be heard, risk management organizations need to

7 Principle 4: Risk Management Organizations Need to be Independent Risk Management Organizations Need to be Independent: To be able to say what needs to be heard, risk management organizations need to be independent from portfolio managers and report directly to the top of the institution. As an independent group, a risk management organization requires competitive compensation that ideally is incentivized by the long-term success of the organization, not short-term investment performance. Compensation levels need to permit the risk management organization to attract and retain the best talent, not only from outside but also internally. 7

Principle 5: Define Your Fiduciary Responsibilities Define Your Fiduciary Responsibilities: To properly manage risk, the client s objectives and their risk tolerance must be understood: o What is the

8 Principle 5: Define Your Fiduciary Responsibilities Define Your Fiduciary Responsibilities: To properly manage risk, the client s objectives and their risk tolerance must be understood: o What is the target return? o What level of risk can the client tolerate? o Which asset classes of securities are appropriate, and what limits should be placed on portfolio construction? Client objectives need to be understood across all functions at the asset manager in order for risk management to work properly. Portfolio Management Client Commonly understood and agreed portfolio return and risk targets Client Management Risk Management 8

9 Principle 6: Bottom-Up Portfolio Risk Management Bottom-Up Portfolio Risk Management: Effective portfolio risk management needs to be built up security-by-security. Bottom-Up risk management requires intensive subject-matter expertise and analytical capabilities. A solely top-down risk management approach relies on assumptions that may mask critical risk attributes of the underlying securities or derivatives. o Seemingly large holdings of low risk securities can turn out to be the riskiest positions. o There have been more cases than bear repeating in which institutions simply did not understand the true risks of their portfolios. Bottom-Up Investment Teams Investment Process Portfolios Securities Top-Down 9

Principle 7: Risk Models Require Constant Vigilance and Skepticism Risk Models Require Constant Vigilance and Skepticism: Wise risk managers understand

Model-based forecasts require many assumptions: o Mean-variance; volatility; correlation; etc. o These assumptions are often very unrealistic.

10 Principle 7: Risk Models Require Constant Vigilance and Skepticism Risk Models Require Constant Vigilance and Skepticism: Wise risk managers understand the limitations of their risk models. o All models are simplifications of reality. Model-based forecasts require many assumptions: o Mean-variance; volatility; correlation; etc. o These assumptions are often very unrealistic. Multiple analytical approaches need to be used to address model limitations. The assumptions in models need to be constantly re-assessed, and if those assumptions no longer hold, the impact on the models needs to be understood. 10

11 Principle 8: Risk Management Does Not Mean Risk Avoidance Risk Management Does Not Mean Risk Avoidance: As an asset manager, risk management should aim to be: o Deliberate: Ensure that only desired risks are taken while undesired risks are avoided. o Diversified: To be efficient, risk taking needs to be spread across the investment universe. o Scaled: Levels of risk need to be consistent with the target returns and risk-bearing capacity of the client. When portfolio risks are understood with confidence, risk takers can be more decisive. Risks can be positioned more precisely to incorporate the desired bet the investor seeks without creating ancillary exposures. For more details on this subject, see: Reflections on Buy-Side Risk Management After (or Between) the Storms. The Journal of Portfolio Management, 36.3 (2010) 11

12 Disclaimer The following notes should be read in conjunction with the attached document: Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: Registered in England No For your protection telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Changes in the rates of exchange between currencies may cause the value of investments to go up and down. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time. Mandates we manage may be exposed to finance sector companies, as a service provider or as counterparty for financial contracts. In recent months, liquidity in the financial markets has become severely restricted, causing a number of firms to withdrawn from the market, or in some extreme cases, becoming insolvent. This may have an adverse affect on the mandates we manage. Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy. This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer. This material is for distribution to Professional Clients (as defined by the FCA Rules) and should not be relied upon by any other persons. Subject to the express requirements of any client-specific investment management agreement or provisions relating to the management of a fund, we will not provide notice of any changes to our personnel, structure, policies, process, objectives or, without limitation, any other matter contained in this document. No part of this material may be reproduced, stored in retrieval system or transmitted in any form or by any means, electronic, mechanical, recording or otherwise, without the prior written consent of BlackRock BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, ishares, SO WHAT DO I DO WITH MY MONEY, INVESTING FOR A NEW WORLD, and BUILT FOR THESE TIMES are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. UNLESS OTHERWISE SPECIFIED, ALL INFORMATION CONTAINED IN THIS DOCUMENT IS CURRENT AS AT MAY

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