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The Risky Business of Investing

Given the enormous importance of risk in the investment business, you’d think that risk management would be fully integrated into everything these investors do. You’d be wrong…

Note to readers: institutional investors are not in the business of making investments or managing investment returns. I know I’ve said this before, but that’s really not what pension funds, sovereign funds, endowments or foundations ultimately do. Investors are, at their core, risk takers. They assess, mitigate, manage, bear and trade risks. If they perform these tasks well, they make money in the process. Risk, then, isn’t just something to mitigate; it’s something to be actively sought out. Risk is the oxygen that gives life to financial markets; it’s the currency upon which all assets are traded. You get the picture.

Given the enormous importance of risk in the investment business, you’d think that risk management would be fully integrated into everything these investors do. But... you’d be wrong. As it turns out, over the past few decades, many institutional investors have moved away from a ‘risk based’ approach to investing and have preferred to think about investing in terms of products and expected returns. This was deemed to be a useful abstraction that rendered modern finance consumable by the masses. However, this wound up be being somewhat problematic, as focusing on returns to the exclusion of risk resulted in some unhealthy distortions in the way we think about investments.

And this reminds me of something that Gordon Clark and I wrote in a recent paper: “In effect, the premium on local knowledge was discounted. In its place, financial products were developed representing segments or slices of asset classes with distinctive industry and geographical characteristics. Instead of trading a handful of companies’ securities based upon expert knowledge or some informational advantage, financial institutions were offered products that carried with them risk and return characteristics based upon historical trends. The design of these products was, and remains, dependent upon simulating their underlying properties, informed by theories of market movement and cross-correlations with other financial products. Instead of a premium on local knowledge, the premium has been on product design and performance wherein relationships with ‘insiders’ have been replaced with relationships between product providers and consumers.”

In short, this new era of finance was all about de-localization and de-risking in favor of the mass-production of products and returns... And, in my opinion, it has been a very bad thing. And this became quite clear when the financial crisis hit five years ago.

Since the crisis, however, risk has taken on renewed significance for institutional investors. From asset allocations and investment decision-making to broader issues, such as governance, operations, and even administration, risk is being returned to its place of prominence in the investment business. But it hasn’t been easy to unwind decades of operational experience. Indeed, this new approach to risk has generated organizational and institutional challenges, as innovation and evolution within large public pensions and sovereign funds can be difficult. Indeed, the inertia of these funds means that focusing investments around risk (which should be a simplification of the investment process) is, actually, very complicated.

Cue this new and interesting report by The Economist Intelligence Unit that was Commissioned by State Street: “Closing the communication gap: How institutional investors are building risk-aware cultures”. It offers a useful read with some unique insights as to how far investment organizations have gotten in their transition away from “products” back to “risks.” Here’s a blurb: “This is the age of the risk-aware organisation. Private and public entities across the globe have scrambled to improve their approach to risk in the wake of the worst financial crisis in 80 years. Investment institutions—for which risk assessment is a fundamental role—are particularly enthusiastic proponents of the risk-aware enterprise. But what does risk-awareness mean to asset owners and asset managers? To what extent are risk processes actually embedded in organisations and communicated across them?”

Drawing on a survey of 297 employees of investment institutions, the report has some interesting answers. For example, it finds that most investment organizations are still not doing a very good job of connecting risk and business functions: “Whereas a majority (52%) of non-risk staff think the risk function exists primarily to fulfill regulatory obligations, only 30% of risk professionals think this. Risk professionals clearly believe their remit should go beyond compliance-type activities... ” ... and so do I!

Anyway, all this is to say that risk is critical to the effective deployment of capital in all investment organizations. But, despite the massive refocusing on risk after the financial crisis, the jury is still out as to whether the changes made by these organizations have resulting in any real improvements.

Focusing on products instead of risks may be an “easy” way to think about meeting return obligations. No doubt the intermediaries on Wall Street and in The City are extremely talented at packaging up products that purport to do any number of things for their consumers. But the abstraction embedded in every financial product serves to remove the investor from its core function: risk bearing and management.

In my view, we all need to spend more time focused on risk and spend less time thinking about over-engineered financial products with innumerable hidden fees and costs...

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