Written by Andrew C. Canter, CFA
Institutional investors face a unique challenge: If they must take risk to meet return requirements, then how can they measure that risk in a comprehensive manner? Integrated risk reporting and management quickly becomes complicated for institutional investors, given the lack of consistency in various systems and reports used by their underlying managers, funds, and investments.
At the 70th CFA Institute Annual Conference, Frances Barney, CFA, discussed how this challenge can be addressed through enterprise risk analysis. Barney, who is head of global risk solutions at BNY Mellon, gave a presentation on effective ways to review all of an investor’s assets for embedded investment risks. (However, this review would exclude normally non-investment risks, such as regulatory risk or longevity risk.)
Barney suggested a few different ways to approach enterprise risk analysis:
- Historical stress testing, for example, looking at draw-downs.
- Value-at-Risk (VaR), based on a correlation matrix with stress tests, to answer questions like “What is the minimum amount by which a portfolio will fall over a given period of time at a given probability?” and “How much will I lose over 1 year at the 5% probability level?
- Exposure Reporting, for example, looking at risk buckets by sector, style, or geography.
- Sensitivity Analysis, testing for specific risks or stressors to see what happens to the portfolio.
All of these methods tend to define risk as “volatility of returns,” although another risk worth measuring is how much you might lose if you want to exit (liquidity risk). Barney recommended looking at several measures of risk, since any one measure on its own will only show an incomplete picture.
However, measuring risk across multiple investments quickly gets complicated: Different asset classes and funds have different reporting styles, timing, and valuations, while different managers can report the same things (such as regional or sectoral definitions) in different ways.
Even looking at funds by their holdings versus their exposures can provide materially different answers about VaR and about how the funds behaved during various crises — for example, you might have a US-listed equity whose business has large non-US or emerging market activities. Barney argued that the best approach is to look through to the underlying business risks, and to do so for all assets in all funds on a range of risk measures in a consistent manner.
Alternative assets, such as private equity and hedge funds, present their own problems; they are inherently illiquid and have weak available data. Barney noted a challenge to complete reporting: “Hedge funds that don’t share any information are the ones that can afford to. Investors will line up at their door in any case.”
These private investments with opaque asset values must be measured via proxy, but Barney thinks that Beta can be used as a risk proxy for unlisted equities.
Ultimately, best practices for enterprise risk management involve taking a uniform approach to assessment and working from position-level information, like the actual holdings of the investment, whenever possible. It’s a detailed process that goes beyond reading the reported VaR information from managers at face value, but it’s a better way to get a detailed picture of the investment risks involved.
Andrew C. Canter, CFA, is Chief Investment Officer at Futuregrowth Asset Management. This article has been adapted from his conference notes.
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