Risk surrounds us, and for investment fiduciaries it is inescapable if meaningful real returns are to be sought. While risk and return constitute the axes upon which investment portfolios are built, return is almost always given primacy in investment policy statements (IPSs) and frequently becomes the main driver of decisions that shape the portfolio. So, how do you balance risk and return objectives in your investment policy?
As a result of this ordering of priorities, risk becomes an output of portfolio construction and asset allocation rather than being regarded as a primary input, which is its proper status. This blog is an introduction to our paper that outlines a practical method by which fiduciaries can assign risk its appropriate place in the formulation of investment policy.
Risks that are specified, defined and accepted become the product of a set of conscious decisions rather than a byproduct of stated return objectives. By striking an appropriate balance between risk and return, fiduciaries can obtain a better understanding of the relationship between the various types of risks that they have accepted and the returns sought for the portfolio and the institution, including the potential negative outcomes associated with their asset allocation and investment policy decisions. This process does not limit fiduciaries to a single portfolio option. Rather, it leads to an objective review of the advantages and disadvantages of the options available.
Once the various types and levels of acceptable risk are agreed upon, a range of portfolios can be produced which conform to them. These portfolios can then be examined and adjusted as necessary to achieve an acceptable and realistic balance between risk and return. In addition to testing whether the projected returns associated with those portfolios meet the needs of the institution, the adjustments may encompass e setting of traditional and alternative asset allocation targets and ranges and also such matters as portfolio liquidity, spending or distribution preferences, and exposures to macroeconomic factors and other sources of return.
In the past, the infrastructure and systems required to support these decisions would have been within the capabilities of only the largest investment firms or endowed institutions, and their interpretation would have been the purview of a small number of academically-trained analysts. Today, however, both the computational capability and the analytical prowess are well within the range of most consultants and outsourced chief investment office (OCIO) firms and, indeed, of many in-house investment staff teams. Since the vast majority of institutions retain the services of an investment consultant or OCIO firm[1] it appears that the expertise and resources required for implementation of a risk-based investment policy are available to most institutions.
At a time when many investors and economists expect low to moderate returns to be the norm for the foreseeable future—and with the impact of COVID-19 still largely unknown—a disciplined approach to risk seems well worth the effort. This is particularly important since low return expectations can cause fiduciaries to increase risk by employing techniques such as the use of leverage or the pursuit of less-liquid investment strategies. At such times, there can also be pressure to reduce spending from the endowment, making the risk of failing to support the institution’s mission all too real.
Institutions will benefit from a better understanding of the relationship between the risks taken and the returns sought for the portfolio; and fiduciaries, ultimately, will enjoy greater confidence that the chosen policies, documented in the institution’s investment policy statement, can better support the institution’s mission through future economic and market cycles.
Interested in learning the details on how to balance risk and investment policy? Download Striking the Balance: A Fiduciary Approach to Risk and Investment Policy.
[1]See, e.g., the 2015 NACUBO-Commonfund Study of Endowments, Fig. 6.4, where an average of 84 percent of participating colleges and universities report using a consultant, and the 2014 Council on Foundations-Commonfund Study of Investment of Endowments for Private and Community Foundations, Fig. 6.4, where an average of 75 percent of private foundations and 72 percent of community foundations report using a consultant.
