Clarifying the concept of risk management

Scientific director at EDHEC-Risk Institute Lionel Martellini, reminds investors of the difference between risk management and risk measurement, highlighting there are some limits to risk diversification.

Recent market turbulence and its strong negative impact on wealth levels around the globe have led private and institutional investors to seriously question the value added by professional money managers. For more than 50 years, the industry has in fact mostly focused on security selection decisions as a single source of added value. This sole focus has somewhat distracted the industry from another key source of added value, namely risk management.

Three common misconceptions about risk management

Risk management is often mistaken for risk measurement. This is a problem since the capacity to properly measure risk is at best a necessary but insufficient condition to ensure proper risk management. Another misconception is that risk management is about risk reduction.

In fact, it is at least as much about return enhancement as it is about risk reduction. In the end, the quintessence of investment management is essentially about finding optimal ways to spend risk budgets that investors are reluctantly willing to set, with a focus on allowing for access to the highest possible performance potential while respecting such risk budgets.

One last misconception about risk management is that it is too often equated with risk diversification. Mistaking risk management for risk diversification again proved lethal in 2008, when sharp downturns in almost all asset classes painfully highlighted the limits of diversification as a risk management technique.

What risk diversification can deliver

Portfolio diversification appears to be a particularly useful source of added-value in investment management since it is the technique that allows investors to design performance benchmarks that can deliver a fair level of performance given the risk taken.

This added-value can be both multi-class where, over a long period, a smart global allocation could significantly improve risk-adjusted performance, or single-class in the main traditional asset classes. It can thereby add value in the equity and bond categories.

In particular, academic research has confirmed that standard stock market and bond indices are severely inefficient benchmarks which do not provide investors with the fair reward given the risks taken. This is because cap- and debt-weighting tends to lead to exceedingly high concentration in relatively few stocks.

A number of alternatives based on practical implementation of modern portfolio theory have recently been suggested to generate more efficient proxies for the performance-seeking portfolio in the equity or fixed-income investment universes.

What risk diversification cannot deliver

Blaming portfolio diversification for not protecting investors in 2008 merely signals a lack of proper understanding of the true nature of risk diversification, which by construction cannot be expected to work in market downturns when all correlations between risky securities and asset classes notoriously converge.

Any attempt at “improving” portfolio diversification techniques based on increasingly complex risk models is also equally misleading if the goal is again to hope for protection in 2008-like market conditions.

When there is simply no place to hide, even the most sophisticated portfolio diversification techniques are expected to fail. One should instead turn to other forms of risk management, namely hedging and insurance, to seek short-term downside protection in such market conditions.

Beyond risk diversification: Hedging and insurance

For a long-term investor facing consumption/liability objectives, risk management should not be understood in an absolute sense, but instead in relative terms with respect to the liabilities: this is the essence of the liability-driven investing (LDI) paradigm that has become the norm in institutional money management, but also is gaining popularity in private wealth management.

In the end, risk factors impacting pension liability values should not be diversified away, but instead should be hedged away. Amongst those, two main risk factors stand out, namely interest rate risk and inflation risk.

One key element that is missing in the analysis presented so far is the integration of short-term (accounting, regulatory or self-imposed) constraints into the design of the optimal allocation strategy. These constraints are not managed through diversification strategies or hedging strategies, but through insurance strategies.

The practical implication of the introduction of short-term constraints is that optimal investment in a performance-seeking portfolio versus liability-hedging portfolio is not only a function of risk aversion, but also of risk budgets (margin for error), as well as the probability of the risk budget being spent before horizon.

From investment products to investment solutions

Meeting the challenges of modern investment practice involves the design of novel forms of investment solutions, as opposed to investment products, customised to meet investors’ expectations.

These new forms of investment solutions rely on sophisticated exploitation of the benefits of the three approaches to risk management, namely
* risk diversification (key ingredient in the design of better benchmarks for performance-seeking portfolios)
* risk hedging (key ingredient in the design of better benchmarks for hedging portfolios) and
* risk insurance (key ingredient in the design of better dynamic asset allocation benchmarks for long-term investors facing short-term constraints).

Each of these represents a so-far largely unexplored potential source of added-value for the asset management industry.