Risk management is the new black – never out of fashion and always reliable. Russell Investments’ director of investment strategy, Canada, Bruce Curwood, explains why risk management is the cornerstone of investing and why now is the perfect time to talk to fiduciaries about their governance structures.
One of the problems with risk management is there is no one-size-fits-all solution. It depends on individual fund circumstances, complexity and purpose.
Risk management is still in its infancy and for most funds that means tackling individual needs via new thought processes, according to Russell Investments’ director of investment strategy, Canada, Bruce Curwood.
“You can’t herd or just follow what the mega funds are doing on risk management, as their objectives, resources and risk tolerance may be different than your own.” he says. “To understand their risk exposures more clearly, funds need to spend more time on risk management.”
As an organisation Russell Investments is passionate about risk, both within its own group, but also in its advice to clients. Last year it launched a risk management consulting business and has put out a risk management guidebook for fiduciaries, with 14 papers on the subject.
Curwood has authored, or co-authored, five of them, including the first two of a three-part series which identifies the reasons institutional investors have trouble managing risk, and also proposes a new way to think about risk management and governance. The third paper was co-authored with Don Ezra and was so lengthy, it required a two-part case study, which is the conclusion of the compendium.
The crux of the problem, Curwood says, is the inequitable amount of time and resources that investors spend on return over risk. To remedy this requires an overhaul of the approach to risk management, and building an organisational-wide risk management framework and culture.
Better governance, Curwood says, starts with understanding that risk management is the cornerstone of investing – that investment management must begin with risk considerations and not with simply pursuing returns.
“Failing to grasp this, most plans have focused on optimising (uncertain) returns rather than managing the level of acceptable risk,” he says.
While he acknowledges the financial crisis caught the industry by surprise in its magnitude and speed, Russell has been advising clients on their risk management approach for more than a decade.
“It is almost the perfect time to talk risk management because the memory of the roller coaster that was the financial crisis is fresh, but markets have recovered. Now people are willing to listen as they understand the downside better, having recently felt the pain during the GFC,” he says.
In Canada a lot of large funds already have tackled governance and risk management practices.
But he says a lot also didn’t fare so well, but are starting to make positive changes. For example, The Caisse and University of Toronto have implemented governance/risk management initiatives over the last several years.
Curwood says the necessary changes start with the governance process, there can’t be good governance without risk management, and vice versa. Key risks are different for each fund and must be identified.
“For a defined-benefit fund, for example, it should be about being in surplus, but often defined-benefit fund plan sponsors will have multiple competing priorities including being in surplus, outperforming the benchmark, and being a first quartile fund, which at different points in time will all compete,” he says. “Defined-benefit funds should have one purpose, to be in surplus (assets that can meet or exceed the liabilities).”
Once that purpose is established and agreed, then a deep dive into the risk management around that should be the next step, including the fund’s risk horizon, capacity and tolerance, with the governance and reporting carved out around that.
“That needs research and an education process for trustees, which is a major undertaking,” he says.
But while the amount of attention paid by trustee boards to risk management before 2007 was minimal, it is improving, with Curwood pointing to the Canada Housing and Mortgage Corporation, whose investment committee he sits on, as an example.
It has an $18 billion insurance fund and a $1.1 billion defined-benefit fund, and 10 years ago the board dedicated 90 per cent of the agenda to history and administration, now about 70 per cent is on risk management.
“They run it like a finance institution, with the resources to match and greater focus on the future, striving to increase governance practices and internal risk management. The qualitative elements (a common sense approach) can often be as important as the quant (statistics). The board need to take ownership of the big decisions, like how much total risk to take, while retaining oversight, tracking to the primary objective and key risk mitigation, but they must let staff implement,” he says.
Russell has developed a hierarchy of fiduciary concerns – which includes more than 50 investment concerns on a matrix of eight decisions (governance, objective setting, asset allocation, asset class strategy, manager/portfolio structure, manager research and selection, execution/custody, and performance measurement/process evaluation) and five risks (fiduciary, asset/liability, structural, implementation, and operational).
According to this matrix, the highest impact are those that are governance and objective setting decisions around fiduciary risks and include legislative/legal, political, decision-making, imprudent delegation, publicity and documentation.
Of course these priorities may change according to each fund’s circumstances which may be determined by different investment exposures, such as foreign exchange, derivatives, liquidity and leverage.
“We work with funds to determine the biggest risks for their plan, and then take the 2-D graph and make it 3-D for them by customising it to their fund and specific circumstance, managing and monitoring their key risks.
“This highlights the vastness of risk management, and how much time and resources they should spend, it has to increase,” he says.
One of the other problems with the thinking around risk management is that funds want a solution, but there is not one tool that can do everything, Curwood says, but the analysis must include VAR, risk budgeting, historical risk, Monte Carlo simulations, stress testing, factor simulation, on the fly metrics, counterparty risk, liquidity risk, volatility risk, equity risk, to name a few.
“You may not need to analyse all of those risks, but they are possibilities. Within risk management clients often want a tool, there is no tool, there are multiple tools and hard work,” he says. “Funds need to understand their risk first and develop a commonality of language so they can communicate effectively.”
