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.”

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.