Welcome back to our seven-part series where we highlight key issues and essential principles of investment management. Part IV reviewed Manager Selection – which provided some questions to consider during the selection process. Now it’s time to discuss principle #5: Risk Management.
Risk can be defined broadly as anything that can result in the objectives of the portfolio not being met. The process of risk management seeks to enable fiduciaries to make the best possible investment decisions in the face of uncertainty and to maximize the likelihood that your portfolio objectives will be achieved. This is accomplished by harnessing those risks for which the portfolio is being compensated while minimizing the occurrence and impact of non-compensated risks.
Investment risks are the most common of the compensated risks. This is when the investment return is expected to be positive in the later stages of its maturity but the productivity of returns in the short and medium term are less certain. When this happens, the portfolio may fail to reach the total return target at any point. It may also fail to have the sufficient liquid income or assets available to be transferred to beneficiaries or the operating budget if needed.
For this reason, your investment return target and funding targets should be rigorously defined and explicitly related to your ability to accept illiquidity and temporary mark-to-market losses. Your policy portfolio should specify these compensated investment risks and expected returns, both as targets and within reasonable ranges.
Not all risks taken during the investment process are compensated for. Certain things like operational and counterparty credit risk failures can occur during any part of the investment process where assets move among managers, agents and intermediaries. Examples of non-compensated risks would be failures in the safekeeping and accounting of assets, a failure to comply with legal or regulatory obligations, failure of a derivative counterparty, or failure to avoid outright fraud. These risks should be avoided as much as possible, and mitigated when they cannot be avoided. Risk management here consists of due diligence to ensure that you are dealing with counterparties and managers of complete integrity and competence, ongoing monitoring of manager and counterparty quality, and diversifying or insuring against unpredictable events.