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Setting standards to deal with risk

We are all, at last, coming to realise in these volatile times that risk cannot be avoided. Indeed, for any serious investor in the equity market, the acceptance of risk has always been essential to the earning of a reward. Ignoring risk is never an option – the question is what to do with it?
The volatility of the markets and especially the volatility within some sectors in the past few years have made people realise that very simple measures such as end-of- month or end-of-quarter risk measurement just lock the stable door after the risk has escaped.
However, we do need to measure risk to be able to manage it. As institutional investors we need to measure risk to avoid surprises. The aim is usually to maximise return for a given level of risk and to optimise the asset allocation process.
So pension funds really need to proactively manage and control risk and accept that this is an important part of the investment management process. As with so much of the process this is much easier said than done.
For a start, there are so many different risks involved in the investment management process.
As Brian Hill, investment consultant from Watson Wyatt, so succinctly put it at a recent conference, a UK pension fund has a huge number of pieces of legislation affecting it. To the astonishment of many of the delegates he went on to name 28 recent acts of parliament and briefly describe 66 other statutory instruments – in other words, 94 bits of legislation that UK pension funds have to comply with. Funds in other European countries are similarly affected.
Different commentators have different views of the risk funds face but we can probably all agree on the importance of asset/liability risk, asset allocation risk, capital markets risk, fiduciary risk, implementation risk and operational risk. However, we lack clear standards in this area in Europe. Funds have no clear concept of what is expected of them or acceptable in this area and there is certainly no codification of best practice
As is so often the case in this industry, it is interesting to look at US experience in the area. I am indebted to Mark Tapley, visiting fellow at Cranfield School of Management, for pointing out to me the existence of a Risk Standards Working Group in the US, originally formed by 11 of America’s most important pension fund movers and shakers in April 1996. Their original concern was the over-use of derivatives, but the agenda quickly widened and by November 1996 they had 33 standards written down and following comments from 70 members of a comment group from all parts of industry they quickly published 20 risk standards covering the management, measurement and oversight of risk.
As far as the management of risk is concerned, matters covered by this US standard include:
q the acknowledgement of fiduciary responsibility;
q approved written policies, definitions, guidelines and investment documentation;
q independent risk oversight, checks and balances, written procedures and controls;
q clearly defined organisational structure and key roles;
q consistent application of risk policies;
q adequate education, systems and resources, back-up and disaster recovery plans;
q identification and understanding of key risks;
q setting risk limits;
q routine reporting, exception reporting and escalation procedures.
In the measurement of risk, the standard covers:
q valuation procedures;
q valuation reconciliation, bid/offer adjustments and overrides;
q risk measurement and risk/return attribution analysis;
q risk-adjusted return measures;
q stress testing;
q back testing and assessing model risk.
In the oversight section are:
q due diligence, policy compliance and guideline monitoring;
q comparison of manager strategies for compensation and investment activity;
q independent review of methodologies, models and systems and the review process for new activities and risk standards.
While I can see real advantages from the application of risk standards throughout the industry from the obvious need not to have to re-invent the wheel every time, to a reduction in costs for the industry. In the end such a move would make it harder for service providers to resist pressures to conform.
However, risk standards do not mean a standardisation in the use of specific risk models. We should appreciate thereal weaknesses in using risk models unthinkingly. After all, a model is rarely a reflection of reality and the past is certainly not a guide to the future.
Risk models don’t portray an ability to outperform but rather focus, possibly too much, attention on one number. In the words of Martin Veasey, head of investment risk at Gartmore Investment Management: “Don’t do risk measurement in a vacuum. Keep an open-minded scepticism and be aware of the shortcomings of models. Risk management is not risk minimisation, but the intelligent application of risk in areas of real conviction.”
The US guide is highly recommended and freely available at the Risk Standards Working Group website: http://www.cmra.com/html/the_risk_standards.html

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