SWFs, Central Banks and Public Pensions Reveal Concerns About Effective Risk Management

Increased exposure by sovereign wealth funds, central banks and public pension reserve funds to new markets and alternative assets is creating new levels of portfolio complexity and within this unchartered territory are fresh challenges, a new report finds.
By Janet Du Chenne(59204)
Increased exposure by sovereign wealth funds, central banks and public pension reserve funds to new markets and alternative assets is creating new levels of portfolio complexity and within this unchartered territory are fresh challenges, a new report finds.

The report by State Street, in collaboration with FT Remark, surveyed 62 senior executives at official institutions, defined as central banks, sovereign wealth funds (SWF) and public pension reserve funds, to explore the opportunities and challenges they face today and in the future. Just under half of respondents were from EMEA and the balance is more of less evenly split between Asia Pacific and the Americas. The total survey participants manage assets worth $5.3 trillion.

The research addressed three areas: the complexity of portfolios that were diversifying away from traditional fixed income, and increasingly towards alternative assets such as hedge funds, private equity, real estate and infrastructure; risk — 25% of respondents were concerned about effectively managing risk; and operational efficiency — how official institutions were changing to take advantage of the new opportunity from changing investment complexity and composition.

Rod Ringrow, senior managing director and head of official institutions for Europe, Middle East and Africa region at State Street noted in particular that SWFs, which have no liability profiles and the ability to take a longer term investment horizon in terms of alternative asset classes, were investing more in the private equity infrastructure space. However, he says, their governing bodies are demanding more in terms of risk reporting and transparency.

The research revealed a general desire for increased emerging markets exposure in the search for yield, with 80% of those surveyed expecting to increase their exposure to emerging market securities over the next two years. This presents new challenges in terms of handling the volatility and complexity of dealing with these types of investments, says the report.

“What we have seen overall in the challenges facing the whole set of official institutions was that managing risk was the highest one, and managing data, stemming from managing risk, was another,” says Ringrow. “Managing data refers to ‘If I use third parties how much information can I share with them?’ In some cases these are all state institutions and the ability to reveal too much is limited. The other challenge that came out was how to improve operational efficiency. I think that surprised us a little bit but perhaps not if you think that we’ve had five or six years of market turmoil and governments are increasingly looking for value for money. As they start to invest in different asset classes, these organizations need to improve the operational efficiency of their back office to be able to cope with that, to be able to manage the risk.

“If you’ve traditionally been a G10 investor how do you grasp a new asset class and the whole question of risk management and data management for something that has not been your traditional asset class is an interesting one that has come through for us. One we thought might have appeared higher on the list is the need to train and talent management — one third of those institutions were concerned about being able to access the right level of talent to make sure they have the effective risk management process.”

The increasing investment in emerging markets has also prompted concerns about data security in dealing with third party providers, as opposed to initially where these institution’s predominantly government bond exposures were held at central banks. “It’s a question of how do you integrate risk and performance within your new model and how are you trying to minimize your operational cost of dealing with new markets and new securities.

“Surprisingly one of the other things is how to cope with all the changing regulatory requirements. The slew of regulations in all these markets means these funds are struggling with and how to bring all these new regulations into their risk reporting structures.”

The research also revealed that the regulatory burden was impacting on certain funds, which were unexpectedly impacted by FATCA for example. “They are asking questions about how these regulations will impact their operations and also the development of talent in risk management.”

In the report, the official institutions revealed the following:

– 51% say the biggest challenge is correctly measuring and monitoring the amount of currency risk they are taking; this emerged as the biggest concern for APAC respondents with 44% saying it’s a challenge to combine different risk measures across asset classes
– 38% cite higher interest rates as a hurdle
– 37% are most concerned about emerging market volatility
– 35% are concerned about the cost of execution going up given collateral issues and additional reporting requirements
– 25% say their biggest investment challenge is managing the complexity associated with alternative investments
– Almost two thirds of respondents (60%) plan to increase investment in their risk management systems and processes over the next two years and 32% of respondents report difficulties hiring employees with risk, compliance and reporting skills
– Improving operational efficiency is considered a significant challenge by 47% of official institutions interviewed
– Meeting the data challenge: 50% say managing data is a challenge. Integrating performance and risk analytics and protecting data security are paramount. In APAC, that statistic rose to 55%

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