Risk Management Practices Continue to Grow for Institutional Investors

Following the global financial crisis, institutional investors have placed more emphasis on risk management and moved from chasing alpha to seeking specific targets.
By Jake Safane(2147484770)
Following the global financial crisis, institutional investors have placed more emphasis on risk management and moved from chasing alpha to seeking specific targets.

In a 2013 survey of over 100 institutional investors from around the world (53% from the U.S., 17% from Canada, 27% from EMEA and 3% from Asia), BNY Mellon found that underachieving a fund’s overall return target is the most important risk policy measure, followed by underperforming against liabilities and then underperforming against a benchmark. BNY Mellon conducted a similar survey in 2005 and for purposes of comparability with the 2005 survey, this current survey focuses on 88 respondents, 36% of which were corporate pensions, 32% were public pensions, 16% were endowments/foundations and the remaining 16% consisted of other types of institutional investors. These investors tended to be quite large, with around 92% managing over $1 billion in assets, and 26% managing more than $10 billion.

Whereas 2005’s survey found that the most important risk policy measure was underperforming against a benchmark, the 2013 survey results show that investors are less interested in chasing alpha and more focused on reaching specific targets. Investors have also significantly increased allocations to alternatives and project to continue doing so, and this trend is mainly a reflection of risk management. 61% said they always or often use alternatives to achieve diversification, whereas only 30% said they do so to compensate for return shortfalls.

As for why risk management has become so important, 68% of respondents said that the 2008 crisis and subsequent economic events such as the Eurozone credit crisis were the biggest factors for implementing risk management practices. 63% said that just the fact that management had an increased awareness of the growing field of risk management caused firms to institute risk management practices.

For managing investments using mathematical/computer-based models, performance attribution analysis is the most common method, with 84% using this technique always or often. 74% conduct a risk/return analysis at the asset class level always or often, 54% do the same for a risk factor analysis of portfolios, and 26% do the same for a newer form of risk management, risk budgeting.

“Institutional investors are up against some formidable risk pressures, from new regulations to transparency concerns to investment risks across the board,” says Debra Baker, head of BNY Mellon’s Global Risk Solutions group. “For many, risk management has been a puzzling proposition—just when they think most risks have been measured, managed and mitigated, new ones emerge and old ones evolve. We see the need for a collective risk management framework that incorporates all areas of risks, their impact on each other, and one’s overall investment program. Using some form of quantitative scoring across major risk categories may be the next frontier of risk management.”

This evolution of risk management has been seen as benefit by 59% of firms, but many are still concerned with the cost and impact of regulation, even if it means better risk controls. These concerns are somewhat regional though, perhaps reflecting the varying degree of regulation in different jurisdictions. 53% of respondents from EMEA indicated that the costs of meeting regulatory changes have outweighed the broader business benefits, yet only 25% of respondents in both the U.S. and Canada felt the same way. Also, 62% of respondents in both the U.S. and Canada indicated their organizations benefited through the evolution of the risk management practice, while only 38% from EMEA felt the same.

Still, risk management appears to only be growing in importance. Over the next five years, 73% of respondents expect to spend more time on investment risk issues and 68% expect to spend more time on operational risk issues. Political risk seems to be more stable, as most respondents expect to spend the same amount of time on this area of risk. In all, 83% expect risk management will play an even greater role in the future than it does today.

As far as improving risk management practices, 75% see a need for better risk reporting to communicate more effectively with non-specialists. And the majority of the respondents think the availability of data inputs needs to improve to ensure risk management becomes more of a science; business practices need to evolve to support enterprise-wide reporting; risk models need to become more sophisticated to accommodate new asset classes and investments; and assembling data needs to take less time in order to achieve true value in risk reporting.

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