Importance of Risk Management for Institutional Investors

Over 80% of institutional investors expect risk management to play an even greater role in the investment decision process in the future, says a new study.

Published by BNY Mellon, an investment management and services provider, “New Frontiers of Risk: Revisiting the 360-Degree Manager” also finds that over the next five years, 73% of institutional investors expect to spend more time on investment risk issues, while 68% expect to spend more time on operational risk issues. Only 25% of respondents, however, have a chief risk officer.

The study, which was done in collaboration with Nobel Prize-winning economist Dr. Harry Markowitz, examines a broad array of risk-related topics and issues, including: market risk; investment risk measures; performance vs. liabilities; credit risk management; emerging markets and non-domestic investing; alternative investments; asset allocation; diversification vs. returns; liability-driven investing (LDI); operational risk management controls; operational risk insurance; liquidity risk; political risk; regulatory change; and best practices.

“Institutional investors are up against some formidable risk pressures, from new regulations to transparency concerns to investment risks across the board,” says Debra Baker, head of BNY Mellon’s Global Risk Solutions group, based in New York. “For many, risk management has been a puzzling proposition. Just when they think most risks have been measured, managed and mitigated, new ones emerge and old ones evolve. We see the need for a collective risk management framework that incorporates all areas of risks, their impact on each other, and one’s overall investment program. Using some form of quantitative scoring across major risk categories may be the next frontier of risk management.”

The new study expands upon material covered in the BNY Mellon’s 2005 white paper “New Frontiers of Risk: The 360-Degree Risk Manager for Pensions & Nonprofits,” which also included input from Markowitz. While the 2005 paper highlighted how the need for more structured and holistic risk management was just beginning to be recognized, the newer study finds that, in the wake of the 2008 financial crisis, risk management has now become a key priority of almost all institutional investors.

“The crisis of 2008 was different. So was the crisis that started in March of 2000 with the bursting of the tech bubble. So will be the next crisis. The moral is that one will never be able to put the portfolio selection process on automatic,” says Markowitz, adding that investments need to constantly be evaluated with the current situation kept in mind.

Markowitz explains that institutional investors should also make sure that higher management understands what assumptions are being made, how and by whom any exotic asset classes being used have been evaluated, and what the vulnerabilities are of the general approach that is being taken. “Furthermore, the push to integrate risk-control at the enterprise level, rather than at the individual portfolio level, should be continued,” he says.

Key findings of the new study also include:

  • No more chasing alpha: Institutional investors are placing greater emphasis on achieving absolute return targets as opposed to outperforming a market benchmark. Risk budgets, matching liabilities and avoiding downside risk all play an important role in this shift.
  • Increased use of alternatives: Study respondents have expanded their use of alternative investments to improve diversification and potentially help with downside risk. Institutional investors plan to increase their allocations to alternatives over the next five years.
  • A re-awakening of risk awareness: The 2008 financial crisis caught many institutional investors off guard. The risk management procedures then in place were widely perceived to be insufficient for a crisis of such magnitude. The drive for more effective, holistic risk management was soon on.
  • Analytical tools on the front lines of risk management: Analytical tools based upon risk-return analysis and performance attribution continue to be the most commonly used to model, analyze and monitor investments. Total plan/enterprise risk reporting tools are on the rise to encompass traditional and alternative investments, as well as liabilities.
  • Avoidance of unintended bets: A desire to avoid unintended leverage and to better understand underlying investments has grown markedly since the 2008 financial crisis and appears to be driving institutional investors toward solutions offering greater investment transparency.

Those queried for the 2013 study indicate that the market events surrounding the 2008 financial crisis and subsequent recession represent their biggest motivator when it comes to focusing on risk. More than 60% of respondents say increased management awareness of the growing field of risk management caused their firm to institute risk management practices.

Over the last five years, 59% of respondents say their firms have benefited through the evolution of risk management, though many remained undecided about the impact, with results varying markedly by region.

The 2013 study also finds a significant shift since the 2005 version, with respondents rating “under-achieving overall return targets” and “underperforming versus liabilities” as their two most important risk policy measures. Between the 2005 and 2013 surveys, these two measures increased more than any other response within this category.

More than 100 institutional investors were queried for the study, including pension funds, and endowments and foundations, with approximately $1 trillion in aggregate assets under management.

The full study can be found here.