Practical analysis for investment professionals
10 June 2013

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

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.

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 the 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 below:

  • Getting Pandas to Breed: Paradigm Blindness and the Policy Space for Risk Prevention, Mitigation and Management: Internal and external pressures force organizations to adapt their decision-making process concerning risk, sometimes with potentially unfavorable results. The author explores the causes and consequences of paradigm blindness that contribute to misguided risk decisions.
  • Downside Risk Aversion, Fixed-Income Exposure, and the Value Premium Puzzle: Value stocks are not a good hedge for fixed-income securities. A portion of the value premium generated by value stocks can be explained by including fixed-income securities in the market index. The authors show that the value premium becomes less pronounced as the proportion of fixed-income securities increases in the market index; the value premium is further reduced when a mean–semivariance framework is used to generate a CAPM-like beta that incorporates downside risk aversion.
  • Private Equity Performance and Liquidity Risk: The authors build on existing research to demonstrate that the diversification benefits of private equity investments are overstated; when the illiquidity of the asset class is taken into account, the alpha of the asset class is actually close to zero. Furthermore, they show that private equity is exposed to the same liquidity risk factors as other asset classes because of a common funding liquidity channel.
  • Are Too Many Private Equity Funds Top Quartile? The process of benchmarking private equity performance data is fraught with biases and is subject to the availability of accurate and standardized information. The authors discuss the complexity involved in and inherent challenges of measuring private equity performance.
  • The Risk Profile of Infrastructure Investments: Challenging Conventional Wisdom: The authors conduct a thorough examination of the infrastructure investment landscape. They focus on volatility comparisons between infrastructure sectors, other industries, and market returns. Controlling for other risk factors, they determine that although infrastructure is low risk and adds to diversification, it does not lead to lower total corporate risk.
  • Measuring Risk for Venture Capital and Buyout Portfolios: The author presents a methodology for estimating risk levels inherent in venture capital and buyout funds. In particular, she designs a systematic approach that produces risk measures more than twice as high as values generated by standard procedure. This improved approach also provides an opportunity to mark to market any alternative asset portfolio in a straightforward yet precise manner.
  • Risky Business: Why Right-Risking, Rather than De-Risking, Is Key for Pension Plans: 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 in pension plans as funded status improves. The author argues that “de-risking” may actually raise the sponsoring firm’s and its plan participants’ exposure to risk.
  • What Determines Corporate Pension Fund Risk-Taking Strategy? The authors show that the level of investment risk taken by corporate sponsors of defined benefit pension plans is dynamic and depends on such factors as the funding level of the plan, the default risk of the corporate sponsor, the taxation basis, the labor unionization coverage, the level of free funds available to the company, and accounting assumptions.
  • Rethinking Portfolio Risk in Asset Management: Existing risk measures for portfolio performance are leading investment managers to misallocate capital. Corrective actions by the investment community can lead to huge payoffs because of better allocations. It is important to remember that opportunity and risk are inseparable and that the returns of hedge funds are not normally distributed, so Gaussian measures are not very helpful. The author contends that the Omega ratio is one measure that can help overcome the misallocation problem.
  • Fixed-Income Portfolio Benchmarks: Time for Reevaluation: 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. Two alternative approaches simultaneously consider active management and the client’s need to meet broader portfolio return and risk objectives.
  • Assessing Strategies in Tail-Risk Protection: Tail-risk hedging is designed to protect investors against tail-risk events, but like other forms of insurance, it involves 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. Not all proposed hedges are obviously worth the cost.
  • Understanding the Risks in Alternative Beta Indices: The number of alternatively weighted equity indices, also called “alternative beta indices,” has risen dramatically since their introduction into the index scene in the mid-2000s. This article provides an overview of popular alternatively weighted index schemes and gives investors a framework with which to understand and gauge the suitability of an alternative index for their desired risk exposures.

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.

Photo credit: ©iStockphoto.com/MaryLB

About the Author(s)
Mark Harrison, CFA

Mark Harrison, CFA, is director of journal publications at CFA Institute, where he supports a suite of member publications, including the Financial Analysts Journal, In Practice summaries, and CFA Digest. He has more than 12 years of investment experience as a portfolio manager and securities analyst. Harrison is a graduate of the University of Oxford.

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