Robust risk management has been an integral part of our philosophy, culture and practices since the firm’s inception. One of our primary roles is to help clients define risks, then go about identifying, monitoring, measuring, managing and ultimately mitigating them everywhere possible.
Risk comes in many forms and has varying definitions depending on each investor’s unique objectives and constraints. Our risk identification and mitigation functions are present at many different levels of our investment and portfolio construction process. From the top down, we categorize our clients’ risks as Investment Policy Risks, Asset Allocation Risks, Traditional Investment Manager Risks and Alternative Investment Manager Risks. Each category has its own list of underlying risks. The following are the sources of different types of risks and how we go about identifying, monitoring, measuring, managing and ultimately mitigating them everywhere possible.
Investment Policy Risks:
We believe that the greatest risk an investor faces is that they fail to properly define their investment objectives (and constraints). If the proper objectives and constraints are not properly defined, it is difficult to create an effective investment strategy, and it becomes just a matter of time before painful symptoms emerge. At opposite ends of the spectrum, symptoms may include suffering investment losses greater than the institution can afford in adverse market environments, or generating insufficient long-term investment earnings to fund a critical spending need.
The risks that result from such a misalignment between the organization’s needs and a fund’s objective are limitless and must be avoided. As a result, we take our clients through a robust three levers exercise, which at its core is a disciplined and systematic risk mitigation process.
The Three Levers are (1) inflows, (2) outflows and (3) required investment returns. The balance among these three components is unique to each investor. Whether a fund’s purpose is to finance a perpetual spending need, pension obligations, a project over a finite period, act as a reserve for a “rainy day,” or for any other purpose, the three levers exercise is critical to determining the appropriate objective.
The process begins with a deep dive into the organization’s purpose, goals, limitations and priorities, which leads to a discussion of not just of an organization’s willingness to take risk, but just as importantly, an organization’s ability to take risk. We think it is critical to thoroughly understand what risk really means for an organization and quantify the “risk budget” before starting any conversations about asset allocation strategy or investment managers.
Asset Allocation Strategy Risks:
Armed with the findings of a robust Three Levers process, we move on to determining the proper asset allocation strategy using our proprietary Frontier Engineer® asset allocation methodology. The Frontier Engineer® is an evolutionary improvement to traditional asset allocation models because it elevates the importance of ‘tail outcomes’ around median expectations. It simulates fat tails, serial correlations and unstable correlations (of asset classes) and accounts for them in the portfolio optimization process. As a result, we believe it is better at identifying, measuring, managing and ultimately mitigating investment risks during the portfolio construction process as compared to more conventional (and naïve) mean-variance frameworks used by most of our competitors.
At least annually and sometimes more often, we use the Frontier Engineer® methodology to update the optimal allocation (as capital market expectations evolve). In the intervening period, we use our Portfolio Engineer® rebalancing overlay, which is another proprietary asset allocation risk-budgeting and management tool we use to measure and mitigate risk. The Portfolio Engineer® takes the risk budget developed during the Three Levers Exercise and quantified during the Frontier Engineer™ optimization process and creates optimal portfolio rebalancing bands. These bands are based on the expected risk and reward of target allocation versus the actual portfolio as markets push the portfolio from its target over time.
We believe our proprietary Frontier Engineer® asset allocation optimization process and our proprietary Portfolio Engineer® rebalancing overlay are vastly superior to competing risk-mitigating asset allocation systems in the marketplace.
Core or Global Public Markets Investment Manager Risks:
Our proprietary manager research process is geared towards identifying subtle qualitative and quantitative characteristics of seemingly strong-performing managers that have significant “blow up” risk, and it winnows them out. We understand and appreciate that a single terrible (or catastrophic performing) manager is capable of destroying all alpha generated by the other managers within a portfolio. The emphasis we put on fully understanding the context behind a manager’s historical excess performance as well as mitigating “tail risks” in our manager research process has been instrumental in helping our clients dodge bullets. For example, managers that generate incremental outperformance only by taking on additional esoteric risks (i.e., less liquid securities, shorting volatility, pushing the credit envelope, etc.) are frequently removed from consideration, regardless of what naïve Modern Portfolio Theory metrics are supposed to indicate. We understand that robust manager risk evaluation goes beyond a naïve historical standard deviation or beta measure.
Alternative Investment Manager Risks:
Defining, identify, monitoring, measuring, managing and ultimately mitigating risks in our alternative investment manager selection process is a multi-faceted qualitative and quantitative process.
We start by evaluating the controls around the process of trading, reconciling, and valuing holdings for alternative investment managers. We must be comfortable with the controls across the entire trading process; from the time the portfolio manager initiates the trade with their trading desk, through the settlement and reconciliation process, and ultimately through valuation and the striking of a net asset value. Key operational processes for hedge funds are performed by outside service providers, including the prime brokers, administrators and auditors.
Our investment due diligence process requires us to understand portfolio construction, including concentration, leverage, liquidity constraints, factor exposures, and constraints such as maximum sector and position limits.