Liquidity is the paramount risk factor for institutional investors to be cognisant of according to Ben Golub, vice chairman and chief risk officer, Blackrock who has co-authored a new paper outlining the risks learned from the credit crisis. He spoke to Amanda White about the suitable internal structure for institutional risk management and the risk challenges at Blackrock.
The right internal structure for institutional risk management is a function of scale. According to career risk manager, Ben Golub, vice chairman and chief risk officer of Blackrock, most people believe the premise that risk management is a good thing, but may not be prepared to pay adequately for it. “One story not told about risk management is that good risk management is expensive,” he says.
There are of course a number of ways to manage that expense, one of which is to have a less-needy portfolio, such as a vanilla asset allocation with a heavily weighted passive allocation.
“Risk management becomes a much bigger issue when you get into extensions on the types of portfolios such as alpha transport, hedge funds, private equity, and those that create increasing complexity in pursuit of higher alpha,” Golub says.
If you are large enough the cost for strong risk management can be less of a burden.
“It is imprudent to assume you get that alpha for free. You need to scale support to prudently service the portfolio.”
Golub says the credit crisis highlighted the rapid evolution of the complexity in products that in some instances went beyond the capacity for participants to risk manage.
“Institutions need to be realistic, if they pursue more highly complex structures and products, then they need to consider that additional organisational risk management costs associated with them.”
Golub was one of the eight original partners who founded BlackRock in 1988 to bring sell-side analytics to the buy-side and form a boutique manager managing complex mortgage securities. Now he heads the risk management team of 140 people who manage the risk across all products as well as counterparty and operational risk of what is now the world’s largest asset manager.
Golub recently co-authored a paper with colleague Conan Crum, associate, risk and quantitative analysis at Blackrock — titled Risk Management Lessons Worth Remembering From the Credit Crisis of 2007-2009 — which highlighted the inadequacy of many standard methods in quantitative risk management during that period.
Personally, Golub says he was surprised at how many aspects that arose out of the credit crisis stressed the paramount importance of liquidity.
“Someone said liquidity is like oxygen, you only notice it when it’s not there. It’s like when you go to a hotel and turn on the light you don’t say this is a nice hotel,” he says. “Financial markets are a utility to convert wealth assets to cash, during the financial crisis that utility failed and institutions couldn’t convert wealth to cash. There was tremendous complacency about that issue.”
Part of that complacency, he says, centres on the proliferation of hedge fund, private equity and unconventional assets used by institutional investors.
While a lot of analysis was done regarding correlations and returns of those asset classes, none of the analysis mentioned the lack of liquidity.
“You have to trade the aggressiveness of a strategy against its liquidity costs.”
He believes institutional investors need to flip the decision-making process when deciding to invest in these asset classes.
“Generally if you are an endowment where you have a long-time horizon and there is no need for producing liquidity then it’s fine. But you need to look at what you need to produce in cash and then set asset allocation. Start with the nature of the institution and its requirements then the portfolio will flow from that.”
By way of example Golub says he recently found out his mother-in-law at the age of 82 had her assets invested 100 per cent in equities.
“When I told her to have more a structured, diversified portfolio, she said she wanted to stay in equities because they would go up. I said historically that was true, they would go up, but I couldn’t tell her if she would still be alive when they did,” he says. “This demonstrates the need to look at individual plans for their liquidity requirements and the financial characteristics of the institution.”
In his paper Golub highlights the paramount importance of liquidity.
The pair elaborate on the importance of liquidity as a risk management tool by emphasising that liquidity is a common risk factor, that cash and cashflow are the only robust sources of liquidity, that price does not include intrinsic value, that complexity and opacity matter more than you think, and collateralisation can be a two-edged sword.
In addition to liquidity, the paper outlines other lessons for investors to consider as a result of the credit crisis including that investors in securitised products need to look past the data to the underlying behaviour of the assets; certification is useless during systemic events; the market’s appetite for risk can change dramatically; make sure the market doesn’t determine your level of risk; the changing nature of market risk; and by the time the crisis strikes it’s too late to start preparing.
While Golub believes lessons are important – “if something happens it shouldn’t really just be something that has happened before” – he says risk management is not just about forecasting the future.
“Another element of risk management under-appreciated is risk mitigation,” he says. “It’s important to have subject matter experts not attached to the portfolio decision making. This provides a different perspective but you can also use them to shift resources around. You can’t anticipate a Black Swan but a good risk management team is a MASH unit for when they do occur.”
One of Golub’s key areas of focus in the next year will be looking at the risk management around the legacy Blackrock and legacy BGI products, how to maintain the best of both systems as well as build a risk management framework on a firm-wide basis.
“As we put organisations together we want to leave intact the quant risk activities but create a firm wide oversight on top of that. At worst it will be duplicative, at best collaborative and it adds another perspective, a firm-wide control,” he says.
“History has shown us that portfolio problems don’t arise solely because of bad formulas, people drive quant processes so we believe strongly in an independent risk management team.”
In 1988 when Blackrock was formed, the aim of the eight partners was to be the best fixed-income manager in the US.
“Now we are saying we want to be the best manager in the world.”
And for Golub risk management is crucial to that purpose.
“When Blackrock first expanded beyond its initial product offerings we decided we were prepared to provide risk management services without asset management but not the other way around,” he says.
