How to Deal With Excessive Risk Concentration?

Jonathan Jacob of Forethought Risk, an independent risk advisory firm, sent me his Benefits Canada article, How to deal with excessive risk concentration:

In my previous column, Examining portfolio risk, we discussed ex-ante risk, ex-post risk and how both measures can provide greater understanding of portfolio risk. In this column I would like to discuss the options that are available to a pension fund manager that discovers excessive risk concentration in a fund through ex-ante risk reports.

When a pension fund utilizes the services of multiple investment managers, there is potential for overlap of risk, causing excessive concentration of risk. Excessive risk concentration can be found in exposure to a single company, a sector of the economy, or a currency among others. If the pension fund manager receives ex-ante reports on risk which aggregate all investment manager portfolios, he or she may recognize an exposure as excessive prior to a potential blow-up.

One potential approach to the excessive risk is to ask one of the investment managers to trim risk to the asset with excess exposure. The investment manager will likely disapprove the request, justifiably claiming that the initial agreement did not include such restrictions and any future measurement of their performance will be tainted by this decision.

An excellent method of circumventing this issue would be the establishment of a “shadow portfolio,” a paper portfolio which would include the original positions desired by the fund manager. This shadow portfolio would not be subject to the restrictions caused by aggregate excessive risk concentration, while the actual portfolio would include those limitations. Over time, the shadow portfolio would once again converge to the actual portfolio either due to the investment manager removing the forbidden positions from the shadow portfolio or due to the pension fund manager lifting the restrictions since other investment managers have voluntarily lightened risk allocations to the asset in question.

A second approach to excessive risk concentration is the use of an overlay portfolio.

The overlay portfolio is a portfolio managed by the pension fund manager to mitigate aggregate risk of the fund itself. The advantages of this approach are its lack of interference with the individual investment managers and the flexibility it provides to the pension fund manager. Unfortunately, it requires greater oversight to ensure proper risk management principles are being adhered to and a lengthy approval process to create such a vehicle.

The final approach is simply an informative one.

The pension fund manager provides the board and trustees with the knowledge that risk concentration is high in a particular asset. The pension fund manager will engage in intense monitoring of the asset in question and only request liquidation of risk at predetermined loss thresholds. This approach allows investment managers freedom to pursue their investment strategies with interference only occurring when necessary. The disadvantage of this approach is the potential for the asset to gap lower, thereby creating losses far in excess of the original threshold. Furthermore, trigger points are occasionally ignored and must be enforced by an investment committee or board.

There are three potential approaches to managing aggregate risk concentration created by multiple asset managers:

1. immediate reduction of risk,
2. use of an overlay portfolio, and
3. the establishment of trigger points for risk reduction.

The optimal approach may vary, depending on the organizational structure of the pension fund. No matter how a pension fund manages the issue of risk concentration, ex-ante risk reports provide valuable information to the pension fund manager with respect to aggregate fund risk exposure and risk concentration.

I thank Jonathan for sending me this excellent comment and I want to expand on it a little. Jonathan correctly states if the pension fund manager receives ex-ante reports on risk which aggregate all investment manager portfolios, he or she may recognize an exposure as excessive prior to a potential blow-up.

Here is the problem: those ex-ante reports have to aggregate risk from all investment portfolios, which include both public and private markets. This sounds easy and straightforward but it isn't. In private markets (real estate, private equity, and infrastructure), you run into stale pricing due to infrequent valuations And in some absolute return strategies, risk aggregation can be very deceptive, especially if it's an illiquid strategy when a crisis hits.

Take a Canadian pension fund that is invested in the commodity and energy heavy TSX, then does private equity ventures in oil and gas, invests in commodity trading advisors (CTAs), in hedge and long-only funds, in commodity futures index, emerging markets, and is long the Canadian dollar. Risk aggregation could be a nightmare if it's not done properly across all portfolios, leaving a fund vulnerable to serious downside risk.

And as far as overlay strategies, you need a CIO responsible for all investment portfolios, internal, external across public and private markets to make the calls and reduce overall risk at a fund. To do this properly, the CIO needs to have excellent risk aggregation reports but that's not enough. This person needs to have a central research team that focuses on leveraging off all sources of information, including the pension fund's external and internal investment managers (knowledge leverage), to produce high quality quantitative and qualitative research for all investment portfolios. This research group acts like the central nervous system of the pension fund and needs to be staffed by senior investment analysts from all groups. Importantly, they need to work well together and work well under pressure, always focusing on total fund risk.

Long gone are the days where risk is only quant oriented. More and more large pension funds in Canada are leveraging off their external partners to add in-depth qualitative research based on rigorous economic and financial analysis. In this environment, you got to think like a Bridgewater. And the bigger you are, the more important this becomes because you have to react quickly, be nimble and be able to take advantage as opportunities present themselves (go back to read my comment on OTPP's Neil Petroff on active management).

Finally, concerning my personal portfolio, I can tell you excessive risk concentration can be very painful when you're concentrated in a certain stock or sector and it's going against you. I've had a wild ride making and losing money with a Chinese solar stock called LDK Solar. Just check out the price action over the last year, and pay attention to the last three months and days (ticker is LDK; click on image to enlarge):

LDK and Trina Solar (TSL) both got whacked on Tuesday, down on heavy volume after Trina guided lower on margins (click on image to enlarge):

OUCH! Talk about a sunburn! Should have listened to Jean Turmel's wise advice! Now, to be truthful, I've traded this stock enough and seen many crazy periods before. I tripled down on LDK when it double bottomed at $5 last year, and I'm getting ready to add to my position (already started and got burned today so now I am waiting).

Chinese solar stocks are not for the feint of heart. When they move, they move abruptly in both directions. You got to buy them when they're way oversold (or wait for them to base after huge down moves on big volume) and sell them when they explode up. A lot of big hedge funds are accumulating and manipulating these stocks, as I will show this weekend when discussing 13-F filings for elite funds in Q1 2011 (I will cover all sectors, not just solars).

Excessive risk concentration matters. It matters for your personal portfolio and it really matters when you're managing other people's money, which is what pension funds are doing. And to properly understand excessive risk concentration, these pension funds need strong quantitative and qualitative analysis across all investment portfolios in public and private markets. While this sounds straightforward and easy, most pension funds lack the tools, systems, external partner relationships and most importantly, investment professionals on the inside who are thinking properly about risk aggregation across all investment portfolios. It's total fund risk that ultimately matters, which is why a lot of large institutional managers got killed in 2008.

***Feedback***

One senior pension fund manager sent me this comment, which sums it up well:

Seeking to manage this risk on some sort of systematic data capture basis seeks false precision, and turns investment management into a giant IT project. What is needed is simply one person, even in a large organization, to stay on top of broad goings on, and on occasion commission staff to do special ad hoc analysis. We used to call this person of experience a chief investment officer...

And Jonathan Jacob added this comment:

Your commenter has a point – it can be difficult to obtain quality data from custodians and that data must be run through a quality assurance process. My article was not so much directed at those large pension funds with significant systems and employee resources but more toward those funds that are severely understaffed (2-3 employees) and who outsource the investment management function to external managers.