by Billy Nauman
If the financial turmoil of the last few years has taught investors anything, it’s that properly understanding and managing the risk in their portfolios is more important than ever. Despite that, several experts say that most institutional investors and their consultants are still not adequately managing, or even properly calculating, the levels of risk in their portfolio.
“Risk is embedded in the investment climate. Everyone is taking risk,” says Russ Mason, president of the Investment Management Institute (IMI). The problem is that many of the institutions he has observed are not properly equipped to manage the risk they are taking on. In fact, he says, many institutions are adding risk despite not having the proper controls in place.
“Unfortunately, many investors fail by not having a risk officer or a team from the investment committee dedicated to risk management,” Mason says. “Investors ought to be thinking about having a risk officer in place, just like they have a compliance officer in place.”
However, for some institutions with limited in-house capabilities, that is not a realistic option. That’s leading some to look outward for help. In recent months many funds, especially in the foundation and endowment space, have moved to the outsourced CIO (OCIO) model, in which a third party is given discretionary control over their portfolios. In addition to other benefits, an OCIO can provide risk management capabilities not typically available to smaller institutions.
The Culinary Institute of America, which, as reported, is currently seeking an OCIO for its $123 million endowment fund, is taking risk management very seriously in its consideration of potential candidates. John Daly, a member of the endowment’s investment committee, says that the endowment is paying special attention to the risk management structures of all of the OCIO providers it is considering in its search. “Risk is very important,” says Daly. “It took the crash of 2008 to wake us up to that.”
While most of the early OCIO adopters have been small or mid-sized funds, many larger institutions are now exploring how outsourcing can augment their in-house capabilities when it comes to risk. According to Chris Bittman, partner and CIO of at Perella Weinberg Partners’ Agility unit, even some larger institutional investors can be “significantly under-resourced” in areas like risk management.
Some investors are now even going beyond traditional consultants or OCIOs and hiring consultants with a sole focus on risk management. Sam Won, managing director at Global Risk Management Advisors, which provides independent risk management services to institutional investors, feels that most consultants and OCIOs do not do enough in regard to risk management. “What most consultants offer in terms of risk is really just window dressing,” says Won, the former global head of risk management at Dresdner Kleinwort Benson and a former head of investment risk management at Citigroup Alternative Investments. He adds that companies like his provide a “check in the system” by independently auditing an institution or OCIO’s investment decisions based on risk.
Some consultants and OCIO providers, though, say that they do, in fact, take risk management seriously, including Wurts and Associates, which advises on $40 billion overall. CEO Jeff MacLean echoes Mason’s sentiment that risk management is one of the most important issues facing institutional investors right now, and says his firm focuses on risk throughout its investment process and advocates for risk based asset allocation.
“We believe that you allocate to risks, not to assets,” he explains. “The problem with asset allocation using mean variance optimization is you end up with a portfolio with 90% of the assets dominated by equity risk. What you need to have is a framework and infrastructure and culture that allow an institution to break out all of their assets and assign risks to those assets and then allocate amongst those risk factors.”
Mean variance optimization is a quantitative means of setting an asset allocation and a method that, according to MacLean, “Only works if you know the future.”
“The outsourced CIO business can help two basic types of clients,” he adds. “The first type of client is one that recognizes that they cannot build an in-house staff themselves. The second type are those funds with well-resourced teams that need to augment their capabilities in some way. There are some well-resourced teams out there that recognize that allocating their assets with mean variance optimization is no longer sufficient.”