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Limits to help technology can provide

Unsurprisingly, software developers say they can help, and many pension funds are turning to technology providers. The Ilmarinen Mutual Pension Insurance Company in Finland, for example, has implemented a risk budgeting application from New York based provider RiskMetrics. Ilmarinen is using RiskMetric’s application on an application service provider basis. RiskMetrics runs the software at its site in London, and Ilmarinen transmits its portfolio data to the application and receives reports back online. This is cheaper than installing the software in-house. “Data management is a really dreadful task, so we went to an application service provider platform,” explains Hannu Nummiaro, strategist at the fund.
Elsewhere ABP, the giant Dutch civil service pension scheme, combines its own risk management model with external providers. “We have developed our own internal risk model. The internal model is on the macro fund level where the assets and liabilities come together and focuses on asset and liability risk, as well as the correlation between them. The liability risk and the correlations with the assets become much more important due to the fair value framework,” explains Roy Hoevenaars, senior researcher within the financial and risk policy department. The fund also uses external providers, such as MSCI Barra, to provide support.
Critics are quick to argue that risk management tools only work when they are not needed, and providers themselves point out that software can only go so far. “In that sense, a lot of risk budgeting quality depends on the correctness of your assumptions. You can use whatever risk modelling approach you like, but if your assumptions are completely wrong, you would not benefit at all,” says Arnaud Leconte, a product managers at Trema, the investment management software provider.
Others point out that risk management tools cannot deal with shocks to the system. “The nature of risk is changing. Risk has always been dynamic, but now it is even more so, to the extent that no amount of risk tools would really help you, because you’re trying to model a risk that doesn’t really exist. We don’t know what risks are going to come in the future. If you try to model something like the events of 9/11, what would you put in your model? There are other variables you can model, like the moment of interest rates, but most of those movements are based on the past,” argues Amin Rajan, chief executive officer of the Centre of Research in Employment and Technology in Europe (Create), the think tank.
Unsurprisingly, providers point out that risk management tools can at least help buffer some of the shock. “Managing risk may not be able to predict shocks, but it can be used to mitigate things you do know about. It may be the difference between blowing up and staying in business, argues Rohtas Handa, executive director at MSCI Barra.
But risk management tools cannot help everyone. Pension fund APK’s Schiendl suggests that smaller pension funds take their time before investing in costly products. “A smaller fund may need to look around for tools that might be available, but it would not make sense to invest big money into systems at this stage, when people are still not sure what questions are relevant to ask,” he suggests.
Handa points out that smaller funds can turn to consultants. “But we are finding that even custodians are playing a role, providing information to the end client, because they want to provide the value added. Tools can clearly be expensive for smaller pension funds. That is why they are turning to consultants and custodians. You also need a lot of human capital – smart, professional people who have knowledge in this area.”

Pension funds also have to contend with the fact that technology sometimes does not evolve fast enough. When using derivatives, for example, technology can be complex and difficult to grapple with. “The hardware technology relating to derivatives is generally very good. However, the issue is of models, mainly on the software side. Derivative models can be extremely complicated, that is why we spend a lot of time checking the models that investment banks use to calculate pricing, when our clients enter into a swap arrangement. Not infrequently, we find errors in these models. The point is that modelling is so complicated, it is not that difficult to make a mistake,” says Watson’s Carter.
Even traditional risk management tools have problems. Some critics, points out Watsons, argue that tracking error does not differentiate between upside risk, the chance of outperforming a target, and downside risk, the chance of underperforming. There is also the assumption that investment returns, in statistical terms, follow a normal distribution. However, often actual returns do not adhere to such behaviour. New risk measures, such as the semi-standard deviation, which can distinguish between upside and downside risk, and is a derivative of the tracking error, should also be considered, says Watsons.
For pension funds, managing even more complicated tools, or monitoring their fund managers’ use of them, might be daunting. But with all the approaches to risk budgeting available, it may just come down to common sense, suggests Create’s Rajan. “Good fund managers rely on gut instincts. That is the best way of measuring risk – they fly by the seat of their pants. Even if you invest in a lot of risk tools, at the end of the day, they are not a substitute for judgement,” he points out.

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