December 13, 2015

Managing risk in a complex world

By Bob Maynard, Chief Investment Officer at The Public Retirement System of Idaho (PERSI)

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.

Over the last few decades, fundamental changes in the investment model have lost sight of this. It has almost become an accepted truth that to be a “sophisticated” institutional investor in a complex, interactive, tightly coupled and adaptive world, one has to adopt a complex, interactive, tightly coupled and opportunistic investment model (and organization). This new approach, which emphasizes non-transparent and illiquid vehicles, relies on quantitative, detailed models of portfolio characteristics as their primary risk control devices.

However, a complex investment world does not require a complex response, either in the nature of the investment organization or the particular investment strategies chosen.

The cockroach lives in a highly complex environment with one of the best long-term success rates of any creature. Yet it has only one defense mechanism – running in the opposite direction from a puff of air. The equivalent for the investment world is, at the core, a very simple structure founded upon public market diversification with one basic defense mechanism: see a volatile movement, react in the opposite direction (i.e. rebalance into it). A simple structure and strategy, if adhered to, has one of the best chances of surviving for many decades.

How risk management changed

Investment life in the early 1990s was easy. The guiding conventional investment philosophy was to have a portfolio that was simple, transparent, and focused: simple, in relying primarily on the public markets over time and maintaining a consistent presence in those markets; transparent, in being relatively easy to understand and explain; and focused, in concentrating extra efforts on a relatively small number of special strategies that would have material impacts on the portfolio.

The resulting portfolio’s risk control relied primarily on the transparency of the portfolio as a whole, and the clear nature of the relationship and behavior to its parts, and only secondarily on extensive quantitative risk models and systems. It avoided investment approaches that used significant leverage or non-transparent structures.

As a result, passive indexing of a diversified asset type was the basic investment vehicle. Portfolios could be constructed using mean-variance models under the assumptions of proportionate return to risk relationships for major asset types and normal randomness. Linear models (with the concepts of “alpha,” “beta,” and a number of related risk ratios) could approximate market and portfolio behavior both for purposes of monitoring risk and as tools to generally predict portfolio behavior.

Because the style or portfolio is very clear and transparent, with daily and independently priced securities, activity can easily be monitored contemporaneously. Unexpected behavior, if it occurs, is instantly clear, and explanations for unexpected behavior can be quickly determined.

This conventional approach came under severe attack in the late 1990s and 2000s because of the growing disparity between the long-term views of the capital markets and the shorterterm behavior of those markets.

In the past decade, the conventional approach moved from being in the mainstream of multi-billion-dollar investment portfolios to an outlier. The investment world moved on to a new model of investing, often described as the “endowment model.” This places much less reliance on major public market exposures and, instead, emphasizes intense active management, illiquid instruments and vehicles, often embraces leverage, and uses many detailed and often opportunistic investment strategies.

It tears apart the traditional asset-class categories of equity and fixed income in favor of supposedly underlying factors, such as “real” returns (commodities, Treasury InflationProtected Securities [TIPS], timberland, real estate), inflation/deflation investments, credit-based returns (high-yield, equity), quality differentiations, and similar categories to reorganize the investments in the portfolio. It requires that risk be managed actively through extensive quantitative models and risk-control systems.

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