Investment policy statements usually contain a section that purports to define the institution’s risk tolerance. But they frequently only gesture in the direction of risk, without actually examining its reality as a matter of investment policy and practice for the institution.
References to risk typically speak of it as something to be “managed” in a general sense. Now, with powerful financial models available to enable fiduciaries to estimate the probability and range of possible losses associated with given investment strategies over time, risk is no longer treated as a byproduct of investment decisions but, rather, a primary input. Moreover, the widespread use of consultants and outsourced chief investment officer (OCIO) advisors provides institutions with the ability to perform the requisite quantitative modeling, thus reducing the complexity associated with factoring risk into the portfolio construction and monitoring process.
At a strategic level, measurable risks include potential outcomes that could impair the institution’s ability to accomplish its mission over a significant period. Examples might be:
- Unacceptably large declines in the market value of the endowment followed by extended periods of recovery in which the endowment is unable to provide the expected support to the institution.
- The inability to maintain sufficient liquidity to meet the institution’s ongoing mission or operating budget obligations in the event that, during bear markets, investments cannot be sold at or near their expected value and credit is not available.
- Insufficient understanding of the behavior of the portfolio under stress, leading to unexpected losses. This can be especially true when securities and portfolio strategies exhibit higher correlations with each other during market downturns.
Apart from these risks, a range of additional concerns may include the legal, operational, credit, environmental, competitive and reputational risks that accompany the portfolio management process. These risks generally can be said to exist at the level of the individual institution or its investment portfolio but can also be exacerbated by the macroeconomic environment and events in the broader financial market.
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, including the potential negative outcomes associated with their asset allocation and investment policy decisions.
Risk Management Comes to the Fore in Periods of Stress. Investment policy statements (IPS) are typically written and updated during periods of relative calm in financial markets. But they are tested when investment, economic, financial and/or geopolitical events lead to a crisis atmosphere. The IPS can be a shield protecting trustees from the pressure to make unwise decisions in such an environment. As a supplement to the IPS, a crisis playbook may help boards and investment committees identify stress points or triggers where operations may no longer be sustainable and then identify the actions they would feel comfortable taking.
Hypothetical questions could include,: What programs might we cut? What expenses could we control? What fundraising opportunities, if any, might be available to us? In short, the playbook is a sound way to guide actions when storm clouds are spotted on the horizon without risking the ship.
How does your IPS account for risk? Has your institution given thought to a Crisis Playbook? If you would like to learn more about risk management in your IPS and more about crafting a strategic investment policy statement download our whitepaper “The Investment Policy Statement: Guiding and Guarding Nonprofit Endowments.”