Ease the Burden of Managing Risk

Patrick Rudden

Risk remains important for many institutional investors, but dealing with it effectively takes time and energy. How investors approach it should therefore depend on their governance capacity.

While equities appear at last to be bouncing back, the memory of the twin bear markets of the noughties decade will not easily fade. Many investors have been seared by the experience and risk remains high on their agenda. But in today’s volatile environment, employing processes to absorb nasty market shocks has its own problems.

Until now, introducing longer-duration, high quality sovereign bonds to a portfolio has been the main shock absorber to stock market volatility. The problem, of course, is that such bonds are trading at record-low yields and therefore provide a less effective hedge against equity risk than in the past.

That’s perhaps why many investors have turned to another shock absorber lately, dynamic risk management (DRM), in the hope of limiting the effects of another global financial crisis on their portfolios. However, we believe that many of the approaches adopted have been reactive and formulaic. For example, some rely on the Chicago volatility index, known as the VIX or “fear index.” When the index exceeds certain threshold levels, DRM will reduce risk assets by a pre-agreed amount. The danger with this is in a 1987-like scenario where a “death spiral” develops: the VIX spikes, prompting a large number of investors to head for the exit, causing a further spike in risk and incrementally more sellers.

The lesson, we believe, is that the cost of managing risk is eternal vigilance, which could prove too high for some investors. Often the “governance bandwidth” is insufficient for the demands made on it. So, for example, an investor who wants to manage risk dynamically must have a process for monitoring markets and making adjustment in something pretty close to real time. Most investors and probably all investment committees are just not flexible enough to do so.

There are several ways to address this governance shortfall. Firstly, just don’t do it. Acknowledge your limitations and set an investment strategy that is simple enough for the level of oversight available. Secondly, empower a chief investment officer or investment sub-committee to make adjustments in something close to real time. Thirdly, outsource. There are plenty of firms, both traditional fund managers and consultants, which are eager to take on the day-to-day burden of managing risk. That should leave the trustees free of the conflicts which come from overseeing both short-term management and long-term strategy, while giving them the time and space to make sure that their portfolio remains on course to meet its overall goals.

The point is that, while investors must take risks to generate the returns they want, the first question they must decide is how much governance capacity they have for the task, and then they must cut their cloth accordingly.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams. 

Patrick Rudden is Head of Blend Strategies at AllianceBernstein.

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