Investment Management Risk is more than investment outcomes. It needs to also address the practical how and processes that support investments and decision making. This paper outlines an end to end approach to investment risk management.
Risk is uncertainty in achieving a goal or objective; meeting an expectation; or satisfying a requirement. Expressed from the perspective of “downside risk”, risk is the possibility of not achieving a goal or objective; not meeting an expectation; or not satisfying a requirement.
Investment risk may be described as the loss of principal; or a rate of return less than expectations or which otherwise should have been achieved (eg missed opportunity within appetite).
Risk at a conceptual level is treated or controlled through any or a combination of: a. Avoidance (eliminate, withdraw from or not become involved); b. Reduction (optimise - mitigate); c. Sharing (transfer - outsource or insure); or d. Retention within appetite (accept, hedge or budget). “Controls” can be used to eliminate or optimise the possibility of risk event occurrence as well as reduce the impact if the risk event occurs.
Investment risk is a type of risk that can be the subject of any of the treatment strategies mentioned. Of note, the investments related processes of portfolio and/or investment design, selection, execution, monitoring, performance assessment, realisation and exit necessarily involve the reduction of uncertainty in achieving investment objectives or requirements as relevant to the investments related process step.
Other risk types may be applicable to investment risk. Examples include: operational risk from failed people, process, system or policy; reputation risk associated with investments; ESG risk; and failure to meet regulatory expectations or compliance requirements, including managing or avoiding conflicts of interest between various participants or stakeholders.
It is the expectation of Boards and regulators that investment risk for superannuation funds is demonstrably well managed at all the investments related process steps. Critically this includes the governance of investments decision making, including the oversight of the management of investments related advice and services and whether that advice or service is wholly or partially “insourced” or “outsourced”. Superannuation Trustees also need to have regard to the overarching performance and other outcomes from the perspective of members.
Examples of investment risk related treatment strategies include: a. mandate restrictions; b. segregation of duties between investment selection and investment operations (including valuations and performance assessment); c. independent validation of investment approach or philosophy (process and calculation, including assumption or parameter verification); d. model risk assessment, monitoring and validation; e. benchmark selection and monitoring; f. portfolio hedges; and g. approaches to incentive alignment between Trustees, members, employees and asset managers, including contract construction.
The treatment strategies for each step will depend on the enterprise context - whether driven externally (market or sector or transaction features) or internally (organisation culture and incentive structures); or business model (insourcing or outsourcing of elements of the value chain).
The external drivers for treatment strategies of investment risk are generally covered by APRA Prudential Practice Guides 530 (Investment Governance) and 531(Valuation). These strategies are dependent on the size, business mix and complexity of the investments with proper segregation of duties between those persons responsible for implementing investment decisions and those persons responsible for investment risk management arrangements. This is aimed at ensuring that investment risk objectives are monitored and managed objectively.
APRA outlines a number of approaches for assessing and measuring the sources of risk that will influence the return of an investment, including combinations of: factor risk analysis, risk budgeting, and alpha and beta source risk analysis, whilst also noting that, in cases where an investor engages in hedging to mitigate risk, an investor should be cognisant of the inherent counterparty and liquidity risks associated with a hedging program.
A key issue will involve oversight, managing and controlling various participants in the investment making processes, particularly at points of misalignment of incentive structures or conflicting business models or strategies. In particular this will include management of asset managers (whether internal or external).