Changes in the institutional investment industry since the late 1990s towards the “endowment model” have led to intricate risk controls that have ultimately damaged investment portfolios, according to the CIO of a major US public pension fund.
Bob Maynard, CIO of the Public Employee Retirement System of Idaho, said: “The best risk control lies in being able to see an entire portfolio easily and being able to spot deviations from the expected without difficulty.
“Transparency should, therefore, be the primary method of risk control in most portfolios.”
Maynard has produced a paper in which he asserts that investors and asset managers have lost sight of the conventional portfolio principles of simplicity, transparency and focus.
He said increasing complexity in today’s investment environment did not mean investors had to respond in a complex way.
With a simple, transparent style or portfolio, with daily and independently priced securities, activity can easily be monitored at the time, said Maynard, who is a member of the international 300 Club of top investment professionals.
“Unexpected behaviour, if it occurs, is instantly clear, and explanations for unexpected behaviour can be quickly determined,” he said.
Maynard said the conventional model of investing “came under severe attack” in the late 1990s and 2000s because the long-term views of the capital markets and the shorter-term behaviour of those markets were growing further apart.
This, he said, had resulted in the adoption of the endowment model of investing, which emphasised intense active management, illiquid instruments and vehicles, and used leverage, as well as many detailed and often opportunistic investment strategies.
“The events of 2008-09 showed that, both in theory and in practice, the endowment model failed its first stress test miserably,” Maynard said.
Markets were extremely volatile, he said, and there was no place to hide.
“Many of the places where the new model took shelter turned out to be stunningly worse,” he added.
He said the problem was there were no risk systems that could currently be based on the mathematics of the “non-linear world”.
“Instead, the only usable tools are risk measures that are based on the assumptions of coin-tossing randomness (such as value at risk, or VaR), linear relationships (such as regression analysis, factor analysis, and concepts of alpha and beta), and the successful identification of potential future stresses and strains on the portfolio (scenario analysis and stress testing),” Maynard said.
These systems could be badly fooled in a non-linear and turbulent market structure, he said.
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