There are currently a number of high profile risk assessment services available to the investment management industry. Upon closer examination, few of these appear to be delivering the goods. The basic thrust of each of the services is that a statistical model of risk is calibrated by reference to historic price movements. Such a model is then used to quantify, given a starting portfolio, the future risk profile of these assets – either absolutely or relevant to a benchmark.
The world in which we live is not so readily predictable, however. This, after all, is what risk means conceptually: the potential for unanticipated events to occur. The financial services industry qualifies every performance claim with the phrase ‘past performance is no guide to the future’, we would point out that the same argument applies to risk models.

Active investment management is about taking risk. Without taking some risk, there is no prospect of beating the benchmark. It follows that risk and return, relative to the benchmark, are inextricably linked and that both are under the control of the fund manager.
The purpose of risk assessment should therefore be twofold: first to ensure that risk is not so low that there is little hope of performance targets being achieved and secondly to ensure that it is not unreasonably high. Within these broad parameters, the fund manager must be left to get on with the job.
There is a major issue with regard to how risk assessment services are used by fund managers. It is hard to believe that there is any almighty black box measure of risk which the fund manager can use, and then simply ignore the underlying concern. Risk matters.
Risk is neither an objective mathematical concept nor some hazy perception of the threat to financial wellbeing. It is a mixture of both. In an ideal world, trustees and advisers would be sufficiently comfortable with the investment process to appreciate inherently the nature and extent of risks being taken. The quantification of risk would then become a secondary issue. All too often the issue is boiled down to a few numbers, or even just one, which actually have very limited meaning.
Believers in efficient markets assert that only stocks with higher, non-diversifiable, risk can offer higher expected returns. Those who follow traditional active management do not share this view. They start with the conviction that markets are, to an extent, inefficient. They accept it is necessary to take some risk in order to achieve an excess return.
The challenge the fund manager accepts in gaining a mandate is to find stocks that will yield an attractive return given the incremental risk brought about by holding that stock. From this it is clear that fund managers who sideline, or ignore, the issue of risk are not doing their job properly.
It seems that some fund managers have taken the view that, by employing a risk management service, they can absolve themselves from responsibility for the investment decisions they have taken. This dependence on an external service that mainly uses past correlations to predict the future, places fund managers on dangerous ground. Subscription to such a service can encourage excessive confidence that the risk factor is being resolved and prevent a major issue that is quite clearly the fund managers’ responsibility from being addressed.
Relying on a black box only restricts the fund manager, and will eventually be his or her undoing. There is also a danger that trustees and advisers may seek to use these tools to absolve themselves of fiduciary responsibility. As argued above, the quantification of risk is crude and is only one piece of the jigsaw. More importantly, trustees and advisers should be comfortable with, and have confidence in, the quality of the investment process which is being pursued on their behalf.
There is another danger in how those risk management services are used by fund managers and trustees. The true risk faced by a funded pension scheme is that the assets fail to meet the liabilities of the scheme. In other words, the risk is that at some future point there are inadequate funds to meet benefit payments. Risk as measured by third parties solely on the risk that assets underperform a benchmark. The total or true risk can be separated into two strands: assets versus benchmark and benchmark versus liabilities.
David Somers is director of pension funds at Clerical Medical Investment Management in London

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