Where Is Risk Hiding Now? Pandas, Tail Risks And Safe Havens

by: CFA Institute Contributors

by Mark Harrison, CFA

Quantification, in an earnest endeavor to get something as slippery as risk under control, has exercised and almost exhausted some of the finest minds and most advanced technologies of a generation. Even so, the efforts of some financial institutions to quantify value at risk (VaR) and other uncertainties, and to establish an effective culture of risk management, have blown up spectacularly at both an organizational and a portfolio level.

One explanation suggests that changing the risk culture of some organizations is about as easy as getting captive pandas to breed. Risk strategies within organizations and in the field of policy and regulation can actually lead to the incubation of paradigm blindness, or unquestioning adherence to one dominant but incorrect point of view, which prevents effective interventions. An organization in which the decision-making process is driven by unquestioned consensus is doomed to failure. By analogy, inflexible strategies in zoos produce lamentably few baby pandas.

A new study demonstrates that existing risk measures for portfolio performance are leading investment managers to misallocate capital. Of course, opportunity and risk are inseparable — even the most conservative foundations can justify investing in hedge funds. But, hedge funds returns are not normally distributed, so evaluating them using regular Gaussian measures may not be optimal. Instead, novel measures may need to be deployed to help overcome this misallocation problem.

At a recent CFA Institute conference, Geofffrey Verter of GMO argued that tail-risk hedging, designed to protect investors against unlikely risks, involves some very material costs. Weighing the cost of a strategy — to the extent that it can be measured — against its ability to insure a portfolio from the consequences of the tail event can be challenging. Quite simply, not all proposed hedges are worth the money.

Even if unforeseen risks are successfully avoided, recent surveys indicate that a significant number of pension plans in the United States and Europe now consider it prudent to materially reduce the level of investment risk as their funded status, or level of solvency, improves. But one new study makes that case that "de-risking" may actually raise the sponsoring firm's exposure to risk.

So where are the safe havens for pension plans and other investors? Perhaps private equity, infrastructure, value stocks, or reliable bonds might suffice? Not so, according to one large study by Francesco Franzoni, Eric Nowak, and Ludovic Phalippou, who say the diversification benefits of private equity investments are much overstated. When the illiquidity of the asset class is taken into account, the alpha of the private equity asset class is actually close to zero. Equally, controlling for illiquidity, the portfolio benefits from investing in infrastructure may be overrated.

Another recent study finds that the benefit from favoring value stocks, the value premium, becomes less pronounced as the proportion of fixed-income securities increases in the market index. And those fixed income securities are tough to benchmark properly, meaning bad data may be distorting inputs into the decision-making process. Speaking at a recent CFA Institute conference, Michael B Zelouf of Western Asset Management observed that the fixed-income investment industry has placed excessive focus on alpha instead of total return and on tracking error instead of portfolio standard deviation. As a result, benchmarks and relative performance may not be appropriate for investors with specific liability targets.

Further reading from CFA Digest's team of abstractors and other CFA Institute resources on risk and related topics can be found on the site.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.