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A better approach to risk management


Diversification used to be right up their with motherhood and apple pie as something you dared not criticise. Tacitly, however, top money managers effectively admitted years ago that, in the form of traditional ‘balanced management’, it was deficient as a form of risk management, with too few assets and an annoying tendency for them to do the same thing just when you need them to behave differently. Managers admitted it by adding more and more assets and strategies to the pot over the years (typically with ever higher costs). But in 2008 even these super-diversified portfolios lost far more money than they were supposed to.

No Monkey Business has been a bit of a lone voice in private wealth management, arguing that diversification is not a risk management tool and that if you want to control risk you have to take risky bets off the table. Risk is about total risky exposures more than about the makeup of those exposures. Over in the institutional space, however, a radical new approach to portfolio management, known as Liability Driven Investment, has been steadily gaining traction, helped by changes in accounting rules that made pension funds much more sensitive to the impact of diversification falling short. The key difference is that risk is managed largely by ‘hedging’ some or all of the liabilities. Bets off the table.

Amongst the leading academics behind this movement is Edhec Business School. Monday’s edition of FTfm included an article written by Lionel Martellini, Professor of Finance at Edhec, titled A better approach to risk management. In it he says:

“For a long-term investor facing consumption/liability objectives, risk management should not be understood in an absolute sense, but instead in relative terms with respect to the liabilities: this is the essence of the liability driven investing paradigm that has become the norm in institutional money management. Risk factors impacting pension liability values, notably interest rate and inflation risk, should be hedged away, not diversified away.”

Professor Martellini also says “investment management is essentially about finding optimal ways to spend risk budgets that investors are reluctantly willing to set, with a focus on allowing access to the highest possible performance potential while respecting such risk budgets.”

Do both statements read across to private wealth? Yes. Private clients’ risk budgets are more likely to be about long-term real spending power than short-term volatility, because the liability is usually future consumption, so it is inflation and equity risk that need to be partially hedged in order to squeeze into the risk budget. Step forward, index linked gilts: the private client’s natural hedge.

The article is available on the FT website (you will have to log in to view). It is timed to coincide with Professor Martellini’s new paper on LDI. This can be viewed on the EDHEC website. Not surprisingly, it is highly technical.

#assetallocation #diversifaction #indexlinkedgilts #ldi #retirementplanning

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