Risk management is the cornerstone of investing

Transcription

1 By: Bruce Curwood, CFA, Director, Investment Strategy SEPTEMBER 2012 Heather H. Myers, Managing Director, Non-Profit Strategy Risk management is the cornerstone of investing For endowments and foundations, adopting an organization-wide approach to risk management makes sense During the past decade, adverse market events exposed a widespread weakness in risk management: the failure to anticipate risk as a fundamental element of investing. What lessons have been learned, and what can endowment and foundation fiduciaries do to protect their assets? Risk (mis)management: a recent history In the high-return market environments that characterized much of the 1980s and 1990s, many investors focused on chasing alpha and all but ignored the fact that risk management is the cornerstone of sound investing. Extended bull markets lulled endowments and foundations into overreliance on expected return as they directed most of their energy to allocations and strategies that did little to mitigate portfolio risk. Four years after the collapse of Lehman Brothers, many investors are still insufficiently focused on risk management. The truth is that determining an appropriate level of risk is far less difficult than accurately forecasting trends and estimating returns. What, then, is going wrong? Russell Investments has identified several reasons many non-profit organizations boards and staff may be failing to fulfill their fiduciary duties. We believe they are: 1. Defining the problem incorrectly by focusing too much on expected return while largely ignoring risk. 2. Narrowly assessing the solution set seeking a single risk management tool instead of establishing an organization-wide risk management process. 3. Underestimating the dynamic complexity of risk. 4. Being impatient and looking for shortcuts, two related human behaviors. 5. Inadequately allocating time by overemphasizing what s easy, i.e., performing merely administrative tasks and relying on historical data. Russell Investments // Risk management is the cornerstone of investing

2 The issues facing endowments and foundations can be further complicated by frequent turnover among board members and staff and by poor documentation; lessons go unlearned and institutional memory shortens. In addition, a dearth of investment expertise increases the odds of group behavioral biases. These and other deficiencies in organizational risk management have been well documented in research conducted over the past 20 years. 1 The element common to all of them is poor governance, resulting from insufficient attention to behavioral issues and inadequate risk management processes. No silver bullet When fiduciaries do look at risk, they tend to define risk management narrowly, as a tool or compliance vehicle rather than a process. Contributing to this problem is the fact that most of the people talking about risk management are trying to sell investors black box models. These models appeal to organizations susceptible to quick-and-dirty solutions that let them feel they have effectively addressed the issue. But buying the black box may not be the answer. Perhaps no one made this point better than Benoit Mandelbrot, a Yale mathematician who used statistics to poke legitimate holes in modern financial theory. For example, in his Ten Heresies of Finance, 2 Mandelbrot challenged the notions that market prices are normally distributed and that they move continuously, assumptions that form the foundation of many conventional risk models. He asserted that markets are much riskier than most people realize, and that current models are used not because they work well, but because the simplicity of the mathematical assumptions behind them is not disputed. Rethinking risk management Despite the abundance of research on risk management, institutional investors have largely ignored the findings. As non-profit investors face the uncertainties inherent in a new normal for the financial markets, it is clear that now is the time to focus on a more robust approach to managing risk. When fiduciaries do look at risk, they tend to define risk management narrowly, as a tool or compliance vehicle rather than a process. PUTTING RISK IN THE PROPER CONTEXT Russell Investments has stressed the importance of setting organizational goals, determining risk tolerance and clearly defining the time horizon the first steps toward understanding and managing risk. The details of these areas, unique to each investor, must be fully explored and clarified. Don t underestimate the time it takes to do this right, as the evaluation of each of these variables may affect your future response to risk. Time horizon is easiest to define, given the long-term focus of institutional investing. Nonetheless, what may be less apparent is that any risk management solution must incorporate a long-term strategic asset allocation time frame of 10 to 20 years, an intermediate time frame of five to 10 years and a short time frame of less than five years, including crisis periods. The latter is particularly important, to help ensure that your investment program can weather a potential market calamity and attain the expected longrun benefits. 1 See, for example, Risk management: A fiduciary s guidebook (Russell Research, 2010). Included is a paper by Bruce Curwood that is also titled Risk management is the cornerstone of investing (pp ). The guidebook is available at 2 Mandelbrot, Benoit, and Richard L. Hudson. "The (Mis) Behavior of Markets: A Fractal View of Risk, Ruin, and Reward." Basic Books, 2004; pp Russell Investments // Risk management is the cornerstone of investing / p 2

3 Goal setting is more of a challenge. The primary goals that non-profits must keep firmly in mind at all stages of decision-making are managing spending, remaining in perpetuity and balancing the needs of current and future beneficiaries. Risk tolerance is even more difficult to discern. Fiduciaries need to address its three components separately, but must also recognize the linkages among them. The three interwoven components of risk tolerance are: 1. Risk psychology a personal trait, such as intelligence, personality or aptitude; 2. Risk capacity a financial consideration establishing how much risk the organization can take while continuing to meet its spending targets; and 3. Perceived risk a subjective judgment about risk, such as the feeling that investing in stocks in a bull market is not as risky as investing in stocks in a bear market. WEIGHING ALTERNATIVE APPROACHES Once investment risk has been put into context, and the nuances of risk have been thoroughly considered, the merits of various risk management approaches can then be appraised. Fiduciaries must understand the complexities of risk and, to be effective, dramatically change the way they think and act. This means adopting an enterprise-wide risk management culture, adopting appropriate risk behaviors and attitudes and developing and rewarding competencies. It also involves having all of the fiduciaries agreeing on their risk management beliefs. There are no shortcuts to changing a culture. Effective risk management requires collaborative and cohesive governance, which fosters top-down oversight, bottom-up involvement for risk-taking and coordinated monitoring of the process. In short, there needs to be continuing, effective communication around risk issues. Fiduciaries must understand the complexities of risk and, to be effective, dramatically change the way they think and act. ESTABLISHING THE RIGHT FRAMEWORK Common sense dictates that fiduciaries pursue an organization-wide approach to risk management in an inclusive process that incorporates both quantitative and qualitative risks. Ideally this organization-wide investment risk framework should address the following nine desirable attributes and six risk management elements. The nine desirable attributes of an ideal risk management framework Risk considerations 1. Has an organization-wide scope, encompassing all investment (quantifiable) and process (qualitative) risks. 2. Demonstrates that return and risk are interwoven. 3. Identifies and describes a general hierarchy of risks. 4. Allows for variations across the investment program in the importance of specific risks and/or risk tolerance. 5. Enables an assessment of risk using both quantitative tools and common sense. Organizational considerations 6. Is owned by the governing fiduciaries. 7. Is clearly articulated and understandable to all fiduciaries. 8. Is practical and proactive in dealing with risk. 9. Can be implemented with results that can be reviewed and evaluated. There are no shortcuts to changing a culture. Russell Investments // Risk management is the cornerstone of investing / p 3

4 The six desirable elements of a standard risk management process 1. Identifies and defines the sources of risk within a fund, such as preservation of capital and spending/ payout policy. 2. Captures the nature of the risks within your total investment context. Possible risk causes and scenarios should be developed. 3. Measures the potential magnitude and impact of those risks on your investment program. Separate minor, more acceptable risks from major risks, and provide information to assist in the evaluation and treatment of risks. 4. Assesses how and whether those risks have been addressed or mitigated by past actions. Develop a list of risks, in order of priority, that require further action. 5. Manages the largest unaddressed risks and utilize a hierarchical approach to sequentially deal with the remainder. Risk treatment involves identifying the potential range of options and preparing and implementing risk treatment plans. Document the process and your rationale. 6. Reviews the risks, continually utilizing the hierarchy, while adding new risks as they are identified. Monitor the delegated risks to the desired outcomes. Set up a procedure for monitoring risk and evaluating the effectiveness of your risk treatment plan. Such an ongoing review is essential to ensuring the relevancy of your approach. 3 Combining these six elements with the nine desirable attributes can yield an organizationwide investment risk management framework that is practical and understandable for fiduciaries. But this alone won t get non-profit investors where they need to be. Better risk management is better guidance What non-profits need is an investment approach that balances growth while helping to minimize the impact of unexpected events. Russell Investments works with non-profits to develop a comprehensive framework focused on understanding embedded risks and unintended biases within the investment portfolio. Risk management cannot be summed up in a number, nor is it an exercise in compliance and box-ticking. It involves a well-defined process and intangibles like human behavior and organizational culture. Douglas Hubbard, author of The Failure of Risk Management, made this point quite nicely when he said:...if you were to implement better methods for measuring risks, then you would have much better guidance for managing risks...to achieve an improvement, however, your organization has to have a way to deal with barriers that are not part of the quantitative methods themselves. You need to break organizational silos, have good quality procedures, and incentivize good analysis and good decisions. 4 A well-crafted approach to risk management is a protocol investment committees, boards and staff can use to help ensure that their investment programs are on track toward achieving their organizational goals. 3 Curwood, Bruce B. A Comprehensive Risk Management Framework for Investment Funds. Journal of Investment Consulting, Summer 2007; pp Hubbard, Douglas W. The Failure of Risk Management: Why It's Broken and How to Fix It. John Wiley & Sons Inc., 2009; p Russell Investments // Risk management is the cornerstone of investing / p 4

5 For more information: Call Russell at or visit Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: September 2012 USI Russell Investments // Risk management is the cornerstone of investing / p 5