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CHAPTER 1
Strategic Risk Management Framework
No one person can do everything required to run a fund well. Intermediaries are employed to act in the fund's best interests.
Board members, for example, are responsible for a fund's management and must consider the benefit of people whose money is in the fund. Also, the day-to-day investment management decisions typically are delegated to investment professionals other than the board members. When you consider the fund as a whole and those involved, the natural question becomes: “How do you best ensure the fund's objective is met with a high degree of confidence?” You could ask the question another way: “What are the key risks my fund faces, and how should I best manage them?” This question is central to all investment management activities.
This chapter deals with the first part of the question; the rest of the book deals with the second part.
ORGANIZING FRAMEWORK
What risks does my fund face? To answer this question, we need a way of thinking about the fund so we can identify the risks within it. Any fund can be thought of in terms of the types of decisions that can be made. This is shown in Table 1.1.
Table 1.1 Types of Decisions
| Fund | Governance |
| Fund's purpose |
| Strategy | Strategic asset allocation |
| Tactical asset allocation |
| Asset class structure |
| Implementation | Manager selection |
| Security selection |
| Execution |
| Review | Performance review/monitoring |
Source: Based on Curwood (2007).
The decision types can be split into four levels: fund, strategy, implementation, and review. Each decision level is described in turn.
Fund
Decisions at the fund level essentially involve key elements of planning for the fund. This means that objectives are established and uses of the fund prioritized. The key statement is the fund's investment policy, which captures the types and amounts of investment risk that are acceptable to achieve the objectives.
As shown in Table 1.1, two decision areas should be covered.
- Governance. Governance involves establishing a framework for ensuring that the fund is run well. Good governance ensures effective oversight and decision-making processes are put in place.
- Fund's purpose. Perhaps the most important decision area relates to the fund's purpose. This is where investment goals and objectives are established; when competing objectives exist, they are appropriately prioritized. How much will be distributed, how stable the distributions should be, and so on are determined. Objectives need to be realistic in seeking to maximize the chances of meeting the fund's purpose.
Strategy
Decisions at the strategy level are concerned with how the fund will go about meeting its purpose. This usually involves setting a long-term strategy (a strategic asset allocation) and deciding how medium- to shorter-term views of the capital markets will affect the fund's asset allocation (tactical asset allocation) and how asset classes will be invested: passively though suitable indexes, usually via pooled funds or exchange-traded funds, or actively using one or many managers to take views on various segments (sectors, countries, or securities) of the market in which they operate.
Three key areas are involved.
1. Strategic asset allocation. The greater the investment returns being sought from the capital markets, the greater the investment risks that must be taken. A strategic asset allocation policy essentially involves determining an appropriate equity/fixed income asset class mix that best meets the objectives.
2. Tactical asset allocation. This involves systematically adjusting a fund's asset mix away from the strategic asset allocation when asset classes are believed to be priced away from equilibrium relationships. Usually tactical asset allocation moves in anticipation of reequilibration of markets, selling asset classes that have strengthened and buying asset classes that have weakened.
3. Asset class structure. This structure establishes how a given asset class will be invested across sectors within the class. It involves issues such as active versus passive management, defines investment styles, and establishes performance benchmarks. If the asset class is to be actively invested, then establishing a suitable investment management structure will be required.
Implementation
The strategies chosen at the previous decision level must be implemented. This involves hiring investment staff or investment managers who are given the responsibility for making day-to-day decisions and the discretion to actually invest the fund. Three key areas are captured.
1. Manager selection. Research is required to identify the best available investment managers, and continuous monitoring that follows.
2. Security selection. This involves research to identify the best portfolio of securities to hold, whatever the asset class. This activity may be undertaken by internal staff or an external manager.
3. Execution. This involves direct interaction with the capital markets and for many funds will involve executing changes across and within asset classes, such as rebalancing and transitioning between managers.
Review
The review stage involves two main elements: (1) what results have been obtained and (2) whether fund expectations have been achieved. Linking back to Table 1.1, performance review and monitoring involve a comprehensive analysis of total fund, asset class, and manager performance versus benchmarks. The monitoring process compares results against their objectives and identifies any changes that may be necessary.
WHAT RISKS DOES THE FUND FACE AT EACH LEVEL?
The decision levels provide the organizing framework for discussing what risks a fund may face. A strategic approach is taken to thinking about risks. But before we continue, we should be clear about what strategic risk management is.
Risk management is often mistaken for risk measurement. Properly measuring risk is necessary, but certainly not enough to ensure proper risk management.
Risk management is not about risk reduction. In fact, risk management is at least as much about return enhancement as it is about risk reduction. In later chapters, this fact becomes clear as we explore the sources of investment returns. Investment management is essentially about finding the best way to spend a risk budget.
Risk management is not risk diversification. Mistaking risk management for risk diversification proved lethal in 2008, when sharp downturns in almost all asset classes highlighted the limits of diversification as a risk management technique.
Table 1.2 shows the decision-types described earlier and aggregate these into key areas of risk. We introduce the key risks here. Subsequent chapters deal with each risk in depth and how to manage risks appropriately.
Table 1.2 Strategic Risk Management Framework
| Fund | Governance | Governance risk |
| Fund's purpose | Asset allocation risk |
| Strategy | Strategic asset allocation |
| Tactical asset allocation | Timing risk |
| Asset class structure | Structural risk |
| Implementation | Manager selection | Manager risk |
| Security selection |
| Execution | Implementation risk |
| Review | Performance review/monitoring | Monitoring risk |
| | | Legend: |
| | | High Impact |
| | High Risk |
| | Moderate Risk |
| | Low Risk |
This table captures the usual five-step risk management process. Risks must be first identified. Then, to the extent possible, they must be understood and measured. Next, they must be managed appropriately. Finally, the results of the process must be assessed. In Table 1.2, we treat each step as follows.
- Identify. We identify seven risk categories: governance, asset allocation, timing, structural, manager, implementation, and monitoring.
- Understand. The seven groups of risks usually line up with certain decision types.
- Measure. This specifically involves ranking the magnitudes of the individual risks. While it is impossible to measure risks precisely, there are four broad tiers for prioritizing fund risks: high impact, high risk, moderate risk, and low risk. In Table 1.2, each is represented by a shade of gray. The ranking is based on the typical hierarchy of concerns that owners or sponsors of funds have. Monitoring risk is shown as the least important, but this is on a relative scale. It is still important in an absolute sense.
- Manage. Once we complete the first three steps, we can deal with managing the risks. Subsequent chapters deal with this.
- Assess. Assessing involves regular review of the four risk tiers in order of importance and their monitoring. It usually involves regular reporting and monitoring of risks to ensure that they are adequately addressed, and identifying new risks as they develop.
We discuss each group of risks in turn.
Governance Risk
Governance risk covers those risks by not having effective oversight and decision-making processes in place. The impact of this risk can be significant. It is the most important to manage since it impacts everything else the fund does.
Next we detail some risks that are captured under this heading.
- Poor governance. Decisions should be taken only by people with the appropriate skills, experience, knowledge, and resources. Sometimes board members engage in investment management tasks—tasks that require day-to-day attention and specialist expertise.
- Hidden investment beliefs. Beliefs usually cannot be proved right or wrong, but they should be defensible. An explicit statement of investment beliefs allows for the alignment of decisions and investments undertaken. Investment beliefs are essential to ensure a fund sticks with well-founded investment strategies during ...
