Playing Risk Management Whack-a-Mole
Risk management can play out as a zero-sum game at times, according to Andrew Junkin, president of Wilshire Consulting.
Strategies to minimize the major risks facing asset owners—drawdown, inflation, illiquidity, active, behavioral, and shortfall risk—can often contradict one another, Junkin wrote in a memo to clients sent Tuesday. “Managing one or more of these critical risks creates tensions with other risks.”
For example, declines in equity markets can inflict “significant damage on an investor’s wealth,” Junkin noted. Yet at the same time, investments in equities help prevent shortfall, or the risk of having fewer assets than financial liabilities.
“It is improbable that asset owners can support their missions without the long-term returns typically associated with equities,” he wrote. “When investors cannot ‘live without’ equities, how can they deal with drawdown risk?”
Similarly, when portfolios are too illiquid, investors face the risk of having insufficient cash to meet short-term needs—a danger that’s compounded by the risk of drawdown. However, that same illiquidity can offer the higher returns necessary to avoid shortfall.
Active risk—gunning for alpha and winding up sub-beta—can also impair asset owners’ abilities to meet their missions. To alleviate this risk, Junkin recommended smart beta factors as an alternative or complement to active management. But true alpha remains “especially valuable.”
To find the right balance between these contradictory risks hedges, he advised asset owners to engage in regular strategic discussions with their boards, consultants, and staff.
“Today’s market environment is not currently in a state where asset owners can be protected from large drawdowns, inflation surprises, and illiquidity while having a double-digit expected return,” Junkin concluded. “Managing risk is an exercise in judgment and is one that must be ongoing if it is to be successful.
Source: Wilshire Consulting
Related: Managing Risk Will Only Get Harder, Asset Owners Warn