Challenges in Financial Risk Encountered by Institutional Investors

Dimensions of Financial Risk Management

The primary goal of risk management is to prevent threats that could endanger an organization’s existence. These threats encompass financial, like market losses and liquidity issues impacting cash flow, and non-financial risks, such as reputational damage. This discussion focuses solely on financial risk, emphasizing that understanding financial risk involves multiple perspectives. Unlike a simple calculation like the value at risk of a portfolio, effective financial risk management requires consideration of various dimensions. This text briefly outlines these dimensions to offer a reference framework, acknowledging the broad scope of risk management as a complex subject.

Top-Down vs. Bottom-Up Risk Analysis

Risk management necessitates adopting both a top-down and bottom-up viewpoint. The top-down approach involves the board and the chief investment officer (CIO) establishing overarching risk parameters for the portfolio. These guidelines act as boundaries within which the investment team operates. Risk management involves assessing, overseeing, and reporting the portfolio’s performance concerning these set guidelines. Meanwhile, the investment team executes the investment strategy by engaging external asset managers or directly handling securities and assets. Their bottom-up approach focuses on managing risks within specific portfolios or asset classes. Simultaneously, they evaluate and monitor how these components interact and influence the portfolio’s overall risk profile.

Portfolio-Level Risk vs. Asset-Class-Specific Risk

Risk management in institutional investing primarily targets controlling portfolio-wide risks. However, managing risks at the level of asset classes or strategies is equally crucial to prevent any single class or strategy from disproportionately impacting the entire portfolio. Various asset classes demand distinct risk management techniques due to their unique characteristics. Metrics and methods effective for publicly traded assets might not be relevant for assessing risks in illiquid or hedge fund investments. The availability of information also differs among asset classes—public equities often offer detailed security-level data, while hedge funds may provide only monthly manager returns.

Analyzing risk for public equities might involve intricate factor models, whereas assessing risk in hedge fund investments might rely on calculating historical return volatility. These differences in data transparency, frequency, and risk assessment methods make it challenging, if not impossible, to aggregate these outcomes at the portfolio level. Consequently, institutional investors commonly employ an overall risk management system for portfolio-wide metrics alongside asset-class-specific systems or approaches. These tailored approaches offer a more comprehensive view of risks within particular asset classes.

Return-Based vs. Holdings-Based Risk Approaches

Financial risk management systems often fall into two categories: return-based and holdings-based. Return-based systems rely on historical return patterns of either an external manager or a portfolio of securities. On the other hand, holdings-based systems derive risk estimations from individual security holdings and their historical returns within the portfolio. These approaches possess their advantages and drawbacks and aren’t mutually exclusive.

Return-based systems are relatively straightforward to implement but can introduce bias in risk estimates because they depend on past returns that might differ significantly from current strategies. Conversely, holdings-based systems are more complex and time-consuming to set up. Many institutional investors dealing with hedge funds and illiquid assets find it challenging to employ holdings-based risk systems due to insufficient transparency on holdings and investment strategies, delayed data availability (sometimes with a one-month to three-month lag), and considerable turnover in particular hedge fund investments. This complexity often makes implementing holdings-based risk systems for the entire portfolio unfeasible in such cases.

Absolute vs. Relative Risk

Investors focus on two fundamental types of risk: absolute and relative. Absolute risk assesses the potential for overall losses and is often measured using portfolio-level metrics like standard deviation, conditional value at risk, and maximum drawdown. On the other hand, relative risk evaluates performance compared to policy benchmarks and is gauged using metrics like tracking error, which measures the deviation of returns from a benchmark.

Long-Term vs. Short-Term Risk Metrics

Modern risk systems utilized by institutional investors primarily focus on computing volatility, value at risk, and conditional value at risk through sophisticated risk factor techniques. These systems heavily rely on the current portfolio structure and detailed modeling of each component, offering estimations primarily for potential short-term losses. However, institutional investors also seek insights into longer-term risks, such as the likelihood of losses, meeting cash flow needs, and achieving specific return targets over extended periods like 5, 10, or 20 years.

To evaluate these longer-term risks, investors often employ Monte Carlo simulation. This method involves simulating asset-class returns based on forward-looking assumptions regarding market elements like expected returns, volatilities, and correlations. It factors total assets, including cash flows such as pension fund contributions, benefit payments, endowment spending, and foundation payouts. While these methods might lack a typical risk management system’s granularity, they incorporate future portfolio changes, diverse rebalancing strategies, and cash flow considerations.

Quantitative vs. Qualitative Risks

Ultimately, risk management isn’t solely about numbers. Quantitative risk techniques rely on historical data and are inherently backward-looking and parametric. While history offers guidance, it doesn’t predict the future. Evaluating potential future losses requires a blend of quantitative tools and qualitative assessments. However, in relying on qualitative judgments, risk managers must be mindful of their biases stemming from personal experiences. Hence, recognizing and addressing the backward-looking bias is crucial in both explicit (quantitative) and implicit (qualitative) risk analyses.

Pre- and Post-Investment Risk Assessment

Robust risk management involves more than assessing existing investments; it entails evaluating financial risks before making new investments. Institutional investors dedicate significant effort to operational and investment due diligence before committing to investments. Besides reviewing past performance, thorough assessments when hiring external managers involve scrutinizing essential decision-makers’ character, the firm’s ethics, team experience, operational quality (like accounting and trade settlements), and risk management practices.

Institutional investors also evaluate non-executive directors’ quality, external auditors’ integrity and independence, fee structures, fund structures, custodians, and asset safekeeping for comprehensive investment due diligence. These considerations become more critical for illiquid investments due to their difficulty exiting. Once invested, risk management might shift toward a more quantitative role, but ongoing diligence and monitoring remain equally essential. Responsibility for this diligence lies with the team accountable for hiring and dismissing external managers or internal management. An in-house risk team often takes charge.

The multifaceted dimensions of risk outlined here highlight the broad scope of risk management as a discipline. In this discussion, the focus centers exclusively on the primary financial risks confronting long-term institutional investors. It adopts a portfolio-level, top-down approach, particularly addressing how illiquid asset classes and the interplay of market and liquidity risks impact an institution’s ability to achieve long-term goals—a risk specific to these investors. Subsequent sections will delve deeper into this unique risk.

Risk Considerations for Long-Term Investors

Long-term institutional investors possess the flexibility to allocate a significant portion of their portfolio to risky and illiquid assets due to their extended investment horizon and lower immediate liquidity requirements. Over the past decades, there has been a steady rise in the allotment to illiquid asset classes like private equity, private real estate, and infrastructure among pension funds, sovereign wealth funds, endowments, and foundations. However, these asset classes introduce distinctive risk management challenges that, if not carefully addressed, can pose existential threats. The fundamental aim of risk management for these institutions remains to ensure their survival and ability to achieve long-term goals.

The discussion begins by outlining the primary objectives of long-term institutional investors and their crucial risk considerations. Exhibit 1 offers an overview categorized by institutional investor type. For each of these investors, the paramount risk revolves around their capability to fulfill the expected payouts they were established to deliver. This risk significantly hinges on the performance of the overall investment portfolio over time.

A conservative portfolio heavily reliant on low-risk fixed-income investments might not hinder short-term payouts but could jeopardize long-term sustainability. Conversely, a complicated and illiquid portfolio may promise high long-term returns but could cause substantial distress during market downturns or financial crises in the short term. Long-term institutional investors try to balance these extremes when shaping their investment policies or strategic asset allocations.

Goals and Risk Factors Across Institutional Investor Types

$$ \begin{array}{l|l|l}
{\textbf{Institutional} \\ \textbf{investor}} & \textbf{Main Objective} & \textbf{Key Risk Considerations} \\ \hline
{\text{Pension} \\ \text{funds}} & { \text{Supply retirement} \\ \text{earnings to plan} \\ \text{participants.}} &
{\text{Failure to fulfill pension} \\ \text{disbursements to recipients.}} \\ \hline
{\text{Sovereign} \\ \text{wealth} \\ \text{funds}} & {\text{Differs based on the} \\ \text{kind of SWF, yet} \\ \text{the majority are} \\ \text{established to} \\ \text{offer forthcoming} \\ \text{financial aid to} \\ \text{the government.}} &
{\text{Failure to offer fiscal aid} \\ \text{to the government.}} \\ \hline
{\text{Endowment and} \\ \text{Foundations}} & {\text{Offer everlasting} \\ \text{financial assistance} \\ \text{while upholding} \\ \text{fairness between} \\ \text{generations.}} & { \text{Failure to offer financial} \\ \text{assistance to the institution} \\ \text{or fulfill the mission.}}
\end{array} $$

This process commonly involves utilizing Monte Carlo simulations, simulating returns across asset classes based on forward-looking market assumptions. It calculates total assets, including cash flows such as pension fund contributions or endowment payouts. This simulation enables institutional investors to compute probabilities like maintaining purchasing power or facing specific losses (e.g., 25%) over set periods (e.g., 5 or 10 years), determining the optimal balance between these metrics.

Yet, often overlooked in this analysis is the crucial interplay between potential market losses and liquidity. Pension funds, SWFs, endowments, and foundations possess unique resilience, tolerating more significant market and liquidity risks due to extended investment horizons. However, their capacity to bear market losses may diminish as they increase investments in illiquid asset classes like private equity, real estate, and infrastructure.

These institutional investors rely on liquidity to meet various obligations like retirement payments, endowment payouts, and portfolio rebalancing. In times of significant market downturns, these needs strain, impacting their ability to fulfill cash flows, particularly if a substantial portion of their portfolio is tied to illiquid assets.

Liquid Requirements and Origins for Institutional Investors

$$ \begin{array}{l|l}
\textbf{Liquidity needs} & \textbf{Liquidity sources} \\ \hline
{\text{Outflows (e.g., pension payouts to} \\ \text{beneficiaries, university payouts,} \\ \text{and financial support to the} \\ \text{government)} } & {\text{Inflows (e.g., pension contributions,} \\ \text{gifts, donations, government} \\ \text{savings)}} \\ \hline
\text{Capital calls for illiquid investments} & {\text{Proceeds from investments lacking} \\ \text{liquidity.} }\\ \hline
\text{Adjusting portfolio allocations.} &
{\text{Earnings from investments and sales} \\ \text{of easily tradable asset categories} \\ \text{like cash, bonds, and publicly} \\ \text{traded stocks.} } \end{array} $$

Risks Associated with Illiquid Asset Classes

Illiquid assets like private equity, real estate, and infrastructure promise higher returns than publicly traded assets like public equity and fixed income. However, this increased potential return comes with a trade-off – illiquidity. These assets often follow a drawdown structure, requiring investors to be prepared for unpredictable capital calls and uncertain profit distribution schedules. This unpredictability in cash flows poses challenges in liquidity management and risk handling for investors in illiquid asset classes.

Managing liquidity needs is critical when investing in illiquid assets. These assets also face challenges like outdated valuations, delayed responses to market movements, and pricing based on estimations, resulting in smoother returns that underestimate actual volatility and correlation with publicly traded assets. These characteristics can mislead traditional asset allocation models despite their attractiveness to institutional investors due to seemingly stable returns. For instance, mean-variance optimization tends to over-allocate illiquid assets because their observed returns exhibit superior Sharpe ratios compared to publicly traded assets.

Moreover, adjusting illiquid asset allocations isn’t easy or cost-effective. While investors might consider selling their private equity holdings in the secondary market, this process isn’t immediate. It often involves accepting a significantly lower price than the asset’s market value.

Cash-Flow Modeling

Illiquid assets operate under a drawdown structure where investors, usually the limited partners (LPs), commit capital that the general partners (GPs) draw down over time. This setup demands careful planning from LPs, who must strategize their commitment amounts annually to achieve desired illiquid asset allocations and anticipate liquidity requirements for capital calls.

Finding the right balance is crucial: over-committing can heighten liquidity risk, causing the illiquid asset proportion to increase drastically due to a decrease in total assets under management (AUM), known as the denominator effect. Conversely, under-committing might hinder reaching the target allocation, potentially falling short of return expectations.

To manage liquidity and plan commitment strategies effectively, investors must forecast future cash flows meticulously.

Managing The Tendency For Illiquid Asset Classes To Exhibit Smoothed Returns.

Institutional investors seeking to gauge the economic risks associated with illiquid asset classes in their risk management endeavors adopt one of two methods. First, they may use public market proxies as substitutes for private asset classes. For instance, small-cap public equities might stand in for private equity. Alternatively, they might choose to unsmooth observed returns from private asset classes.

The latter method eliminates the serial correlation structure observed in the return series. It assumes that the reported returns’ serial correlations result entirely from the smoothing behavior employed by funds when reporting results. One commonly used technique, introduced by Geltner in 1993 to address appraisal-based valuations in real estate, removes only the initial-order serial correlation in observed returns. Okunev and White furthered Geltner’s method in 2003 by incorporating higher-order serial correlations.

Another method, the GLM technique developed by Getmansky, Lo, and Makarov in 2004, assumes that observed returns for illiquid asset classes and hedge funds follow a moving-average process. These approaches aim to enhance the accuracy of assessing the actual risks associated with illiquid asset classes for institutional investors.

Direct vs. Fund Investments in Illiquid Asset Classes

Recently, significant pension and sovereign wealth funds have favored direct investments in illiquid assets over the traditional LP-GP model, aiming to cut substantial fees paid to GPs, which can reach 2% on committed capital and 20% on profits. This shift toward direct investments affords investors better control over individual assets, enhancing liquidity management and avoiding unfunded commitments.

Yet, direct investments require adept in-house teams, and while some investors acquire general partners instead, this approach brings challenges. Building an in-house team can limit diversification due to reliance on team capabilities for deal sourcing. This method might increase concentration risk and scalability issues for direct investment portfolios.

Other concerns encompass reliance on external managers, risks of adverse selection, governance structure limitations, heightened liability issues, and the challenge of attracting and retaining talent, especially in public pension funds with restricted compensation. These factors pose significant complexities and trade-offs for investors considering this approach. Overall, while direct investments promise to control and potential cost savings, they entail intricacies related to talent, diversification, liquidity, governance, and liability.

Managing Liquidity Risks

1. Set up parameters to assess liquidity risk.

   Institutional investors commonly set liquidity guidelines, specifying the proportion of assets available daily or monthly. They track both invested capital and uncalled commitments due to illiquid assets’ drawdown structure. Typically, these investors establish internal benchmarks for the combined sum of invested capital and uncalled commitments concerning total assets. These guidelines often include triggers, like scaling back commitments or initiating secondary sales, when this combined sum reaches a specific threshold as a percentage of total assets. These liquidity risk parameters may be internal guidelines or part of an investment policy approved by the board.

2. Evaluate the portfolio’s liquidity both presently and its evolution over time.

   Managing liquidity risk at the portfolio level requires thoroughly evaluating the portfolio’s liquidity against predefined benchmarks. Institutional investors regularly maintain an internal report outlining the liquidation potential across different time frames within their portfolio. This ongoing assessment isn’t just a static snapshot but serves to monitor changes in liquidity as the portfolio evolves.

   The process starts by reviewing legal terms with external managers, especially crucial for active managers and hedge funds with stipulated redemption notices and lockups. Internally managed portfolios involve a more nuanced analysis considering asset types, utilizing market-based liquidity measures to project potential sell-offs, especially during financial crises.

   Additionally, investors must factor in the impact of redeeming investments from specific external managers during crises, potentially influencing future relationships. This consideration might lead to holding onto seemingly liquid investments, categorizing them as less liquid to maintain favorable relationships.

3. Create a cash flow model to forecast anticipated future cash inflows and outflows.

   The third step involves comprehending and modeling various cash flows. As explained earlier, institutional investors engage in payouts (like retirement benefits or foundation spending), receive inflows (such as gifts for an endowment or pension contributions), fulfill capital calls for illiquid assets, receive distributions, and conduct portfolio rebalancing. Typically, these investors develop models for each cash flow category, projecting future expected cash flows.

4. Subject cash flow projections and liquidity needs to stress tests.

   Conventional cash flow projections function under normal business circumstances. Yet, stress testing these projections and liquidity needs is critical. Market shifts impact cash flows; crises can reduce donations and increase payouts. Institutional investors conduct stress tests on their cash flow projections and liquidity needs. It’s essential to recognize that this approach is more subjective than objective, lacking a universally recognized methodology akin to market risk calculations.

5. Create a contingency plan for emergencies.

   Institutional investors should create an emergency action plan detailing asset liquidation priorities and portfolio rebalancing strategies during crises to meet cash flow needs. This proactive approach curbs impulsive decisions. Sharing the plan with the board garners consensus and reduces the risk of the investment team succumbing to short-term pressure and making suboptimal choices during crises.

Question

Which of the following is least likely a challenge institutional investors commonly encounter when dealing with illiquid asset classes?

1. Predictable cash flows and capital calls
2. Delayed market responses and outdated valuations
3. Difficulty in adjusting asset allocations and delayed secondary market sales

Solution

The Correct Answer is A.

The statement is least likely a challenge faced by institutional investors dealing with illiquid asset classes. One of the primary challenges with illiquid assets is their unpredictable nature regarding cash flows and capital calls due to the drawdown structure.

B is incorrect. Delayed market responses and outdated valuations are challenges commonly encountered by institutional investors dealing with illiquid assets. These assets often face challenges with delayed responses to market movements and valuation methods based on estimations, leading to outdated valuations.

C is incorrect. Institutional investors commonly face challenges adjusting asset allocations due to the difficulty and delay in secondary market sales associated with illiquid assets. Selling illiquid assets in the secondary market often involves accepting lower prices than their market values, which can hinder adjustments in asset allocations.

Reading 16: Cases in Risk Management – Institutional

Los 16 (a) Discuss financial risks associated with the portfolio strategy of an institutional investor