Is Risk Measurement Damaging Long-Term Performance?

(March 6, 2012) — Many investors are mistaking ‘risk measurement’ for ‘risk management’ and hurting their long-term prospects of meeting investment goals, investment consulting firm Towers Watson claims.

Investors should implement a tougher framework to measure risk and employ better governance to manage it using a series of adaptive buffers, the consulting firm says in a paper this week.

The paper, entitled ‘The Wrong Type of Snow’, addresses how pension funds, and other large investors with liabilities to manage, should tackle risk rather than just identifying it.

Tim Hodgson, Head of the Thinking Ahead Group at Towers Watson, says: “Central to our new thinking on risk is the context of a fund’s mission – the long-term value creation proposition. We are increasingly defining risk as ‘impairment to mission’, or as ‘surviving the whole journey’, and are introducing the concept of adaptive buffers into our advice.”

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The paper says that too often investors are mistaking risk measurement for an understanding of what it meant for their portfolios and liabilities.

Hodgson said: “These buffers are mechanisms, both financial and non-financial, that are available to the investor to support them through adverse periods and can be used with a consideration of different potential future scenarios to evaluate how much risk a fund should be taking. We believe a risk ‘sweet spot’ exists whereby enough risk is taken to generate wealth, given the available buffers, but not so much that mission is likely to be permanently impaired.”

For the sponsoring company, these buffers include having financial capital that could be called upon either on a contingent basis when a shortfall is projected or on a realised basis when the journey plan fails to deliver agreed pensions.

For chief investment officers and trustees, their adaptive buffers include having the political capital of board members in drawing an increased willingness to providing financial support from the sponsor covenant.

The paper adds that allocating assets on a risk basis is growing in popularity, and although only a few investors have adopted the technique Towers Watson says the approach has merit.

Using the approach, based loosely on the ‘risk parity’ approach in the United States, the paper presents a portfolio showing how allocation to various asset classes could be achieved while keeping a steady hand on a risk budget.

Through the use of leverage and managing relatively high volatility, Towers Watson says it created a portfolio that would enable an investor to hit their required investment return target, but with lower than average risk.

For a closer look at ‘risk parity’ in Europe, click here.

Investment firms must do a better job of being both 'asset gatherers' and 'investors' to build and sustain a business, according to Janie Kass of Margolis Advisory Group.

(March 5, 2012) — The notion that investment firms can use one of two extreme approaches—asset gatherer or investor—to build and sustain a business is both unrealistic and overly simplistic, according to Janie Kass of Margolis Advisory Group.

In a conversation with the author, Kass told aiCIO that the paper’s key takeaway is that investors must do a better job balancing the investing side and the business side of their work. “For too long in our business there was a myth that either your firm was investment driven — perceived as good — or an asset gatherer — perceived as bad,” Kass said. Investment-driven firms are perceived as being driven by performance, which is beneficial for clients, while asset gatherers are perceived as being solely concerned with gathering assets for the firm to the detriment of their clients and their returns, she added.

“Individually these approaches cannot facilitate long-term success, as both asset growth and solid investment performance are necessary for initial growth, client retention and sustained vibrancy. That is why firms that adopt the blended ‘asset grower’ mentality are best positioned for lasting success,” Kass writes in a recent paper titled “Asset Grower: The Ideal Blend of Asset Gatherer and Investor”.

According to Kass, either extreme is unwise. “You need to balance the investment needs with the business side. That’s the key. The client is obviously the most important constituency because without them the firm doesn’t exist.”

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In an aiCIO video in September, Charles Ellis, an author and consultant to large institutional investors in the US and Asia, voiced another critical perspective of the investment management industry.

“As a profession, let us correct our two errors of commission—defining our mission as ‘beating the benchmark’ and letting the short-run economics of our business dominate the long-term values of our profession. If we correct our error of omission by reaffirming investment counseling in our client relationships—as we certainly could—we and our clients will both benefit in a classic win-win situation.”

Ellis concluded that as investment management organizations have been growing, it is not surprising that business managers have increasingly displaced investment professionals in senior leadership positions or that business disciplines have increasingly dominated the old professional disciplines. “Business disciplines focus the attention of those with strong career ambitions on increasing profits, which is best achieved by increased ‘asset gathering’—even though investment professionals know that expanding assets usually works against investment performance,” he wrote in a paper.

Thus, according to both Ellis and Kass, for businesses both large and small, it is important to avoid the tendency of focusing purely on business profits at the expense of clients’ needs. “It’s imperative to balance asset gathering and investment needs for long-term success,” Kass said.

VIDEO: See Charles Ellis on the Winners’ Game of Investing