The Rise of the Risk Factor
Jeffrey Scott on why diversification is no longer enough.
BY Scot Blythe | June 28, 2012
The 2012 Risk Management Conference (August 21-23 in Muskoka, Ontario) will see the return of Jeffrey Scott, the former chief investment officer at Alaska Permanent Fund who first presented at our Global Investment Conference in 2011. These days Scott is responsible for leading manager research and risk allocation at Seattle-based Wurts & Associates. During the conference, he’ll present a hands-on workshop to help plan sponsors deal with the new realities of risk management in a low growth world and will be joined by Max Giolitti, director of risk allocation at Wurts & Associates. In advance of the conference, we asked Jeff to tell us about how he defines risk and what factors plan sponsors need to focus on today.
You argue that risk is more than statistical volatility.
I think that you can stomach volatility over a short period of time as long as your assets are continuing to grow. But what happens if that volatility leads to a drawdown that is greater than what the organization can stomach? What will happen is that the organization will make changes at probably a very inopportune time. It’s really the drawdown or the tail risk, so when people are looking at measuring the volatility of historical returns, or looking at implied volatilities, it really misses the point of the bigger issues. The bigger issues are losing too much money. The bigger issues are not meeting the liabilities and not meeting the objectives.
You could lose money and have risks that go beyond that of volatility of returns. For example, you can lose money in securities lending, which is not going to show up in your volatility measure. You could lose money in your collateral agreements against counterparty exposure. You could miss cash-flow liabilities because your money is tied up. You could have a ton of money in private assets that appear to have low volatility but end up creating a cash-flow liability that you can’t meet.
How do you restructure the risk framework?
We try to measure and monitor risk through many different lenses. We take a look at assets that are packaged by Wall Street and look at the decomposition to the specific risk factors associated with it. There really isn’t a free lunch in these asset classes. If you’re getting a return, you have to try to understand what are the risks you are taking to obtain that return. Oftentimes there are embedded tail risks that are quite large and you’re not getting a very good return for that risk.
Those risks could be liquidity risk, it could be future funding risk or capital calls, it could be interest rate risk, currency risk… there are actually some securities that have volatility risk embedded in them, for example, mortgages or convertible bonds, stock options, warrants.
What we have to do is take a look at the assets that are sold to us and ask what is this asset’s composition of risk factors and what do we believe is the return opportunity for this risk that we are taking? Does this risk have unintended consequences or a left-tail event that we’re not comfortable with?
What clustering of risks are you discovering?
In the past, the world was broken down into stocks, bonds and alternatives. What happened is that if you look at traditional allocations there’s this beautifully coloured pinwheel: small-cap equities, international equities, emerging market equities, frontier equities, and then, lo and behold, another alternative called private equity. Just within that equity structure you get this visual perception that you have diversification, but when you look at it from a risk-factor standpoint, you don’t.
Take a simple portfolio that has 60% equities with that beautifully coloured pinwheel, and 30% bonds, again with a coloured pinwheel: the Barclay’s Aggregate, high-yield debt, distressed debt, mortgage-backed securities, emerging market debt, and then 10% in alternatives, let’s say private equity and real estate. Visually you think that you have diversified your portfolio because that’s what Harry Markowitz taught us in his Nobel-prize winning model, that diversification is a free lunch. However, when you look at it through different lenses, and specifically a risk-factor lens, roughly 85% to 90% of the risk is one risk factor: the equity risk factor.
If you had 90% in your eggs in one basket, would you really think that that was diversified? In reality it’s not, you have all of your risk concentrated in equity risk factors. If you really look at the returns, it’s based on animal spirits: that is price appreciation. Whether the stock market goes up or down, based on animal spirits, that’s what’s driving your annual returns.
We look at this through these different lenses, rather than the coloured pinwheel pie of different asset classes, and say what are the risk factors, what is the geography, what is the return contribution, what is the economic sensitivity? Most of these portfolios are built on of growth and prosperity and will not do very well in a deflationary environment, or an inflationary environment, for that matter.
To find out more about Jeff and Max’s presentation and the Risk Management Conference, click here or to learn more about the Risk Management Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Garth Thomas to be considered, as limited space available.