For those financial institutions which have yet to grasp the importance of identifying, measuring, managing, and monitoring risks on a comprehensive basis, time may not be on their side. Regulators and litigators alike are forcing change.
There are countless individuals who want better information from their service providers about risk and are prepared to vote with their feet if they don’t get good answers. After all, these institutional investors themselves are confronted with a bevy of new mandates that require transparency. The good news is that change opens the door to business opportunities. Enlightened organizations that have good processes in place and have nothing to hide can differentiate themselves from competitors. Providing clients with education and data tools offers yet another way for asset managers, consultants, banks, and advisors to forge stronger relationships with their pension, endowment, foundation and family office clients. On the flip side, those who are reluctant to explain how they manage their financial, operational and legal risks may lose clients or worse yet, could end up as defendants in a lawsuit.
Pay to play conflicts, questions about hidden fees, state and federal legislation and new accounting rules are a few of the forces at work to ensure that trillions of institutional dollars are in good hands. Effective investment stewardship is no longer a luxury. Recent surveys confirm that buy side decision-makers continue to emphasize governance and risk management for their organizations as well as providers of products and services. Institutional investors can ill afford to lose money after a tumultuous few years. Investment committee members who give short shrift to fiduciary duties could end up being investigated by regulators or sued. According to federal court data, the number of ERISA lawsuits is going up. Factor in investment arbitrations, enforcement actions and “piggyback” securities litigation allegations and it is clear that unhappy investors are not going to accept the status quo.
1. Fiduciary Focus
Besides efforts underway by the U.S. Securities and Exchange Commission (SEC), the U.S. Department of Labor (DOL) has proposed an expanded definition of who should serve as a fiduciary to ERISA employee benefit plans. If adopted, countless more professionals will be tasked with demonstrating procedural prudence when it comes to the investment of over $30 trillion in money from corporate retirement plan sponsors. States are likewise seeking change in the form of trust law reforms that tighten accountability for the investment of monies held by endowments, foundations and charities. The questions now being addressed by judges and arbitration panels relate to “excessive” risk-taking, insufficient diversification, absence of independent assessments of hard-to-value instruments and oversight failures that have led to large losses that might have been highly preventable.
One asset management firm recently settled with the SEC for $242 million over a mistake with one of its risk management models. Another firm just settled with the SEC for $200 million due to problems in the way subprime securities were marked. A few years ago, a Northeast pension plan was sanctioned by the DOL for not having thoroughly vetted valuation numbers provided by one of its hedge fund managers.
When I testified before the ERISA Advisory Council in 2008, I emphasized that having good valuation policies and procedures is essential because it impacts so many decisions having to do with asset allocation, hedging and fees paid.
2. Data Mining for Gold
Data analysis is a cornerstone of effective risk management but only if inputs are considered good. Garbage in, garbage out can be disastrous and costly. The use of unreliable, incomplete or inaccurate data points can result in bad decisions being made about measuring and controlling risks. Since risk management is integral to investment management, other decisions such as portfolio rebalancing may be flawed as a result. Moreover, data is not created equal. Consider a few examples. Yields for a constant maturity security are not the same as yields on particular financial instruments with a fixed maturity date. Betas can be levered or unlevered. Mutual fund returns may not include all relevant fees, let alone the timing as to when the fees are charged. Hedge funds that utilize side pockets will report performance numbers that are skewed as a result. For an institutional investor that is trying to decide how to best manage risk or make sure that its service provider is properly controlling risk, one has to first measure the numerous risks that can spell trouble if left unchecked.
I’ve been fortunate to have worked on various projects where I had to thoroughly understand data quality exigencies before I could conduct statistical analyses that in turn were used for risk management or compliance purposes. While pursuing my PhD in finance, I took extra math and statistics courses to strengthen my data analysis skills. My doctoral research on trading patterns and market liquidity required extensive vetting of transaction data that was provided by the New York Stock Exchange. When I worked in the treasury department of a Fortune 500 company, I had to review and assimilate large amounts of data about a $200+ million derivative instrument portfolio in order to make recommendations about hedging strategies and risk monitoring technology functions. When I now serve as an expert witness on financial litigation matters, I spend copious amounts of time with relevant data to first understand what it means and then evaluate what could have been done differently to avoid losses. Data analysis is an important component of estimating economic damages that a judge or arbitration panel will review for settlement or award purposes.
Making decisions based on numbers alone is not the way the business world works. There are qualitative and quantitative risks that cannot be ignored but, of course, decisions and data do need to be aligned.
3. Everyone is a Risk Manager
There is no sector of the investment management industry that is immune from risk management. Due diligence meetings increasingly focus on what asset managers, banks and other service providers are doing to manage their risks. Pension committee members are being asked to account for how they select managers and investments with more details about prudent process. Donors are reluctant to give money to non-profits without assurances that risks are under control. Auditors are tasked to ensure that models for hard-to-value instruments are regularly monitored for appropriateness. Board members and compliance officers are in the spotlight for their oversight of risk-taking and the extent to which investors are kept abreast about controls.
Risk management is an important means to an end. It is in everyone’s best interest to identify, measure, manage and monitor risks. Otherwise, it comes down to being lucky or not. Try explaining whim to investors, shareholders, taxpayers, litigators and/or regulators.
In addition to a plethora of articles about risk management and valuation, Susan Mangiero, PhD, CFA, FRM is the author of Risk Management for Pensions, Endowments and Foundations. She is busy at work on a new book about investment risk governance. Mangiero is the architect behind an award-winning, syndicated blog found at www.pensionriskmatters.com. A second blog found at www.goodriskgovernancepays.com focuses more broadly on investment risk governance for all types of institutional investors and their advisors and attorneys.
Contributed by Susan Mangiero, PhD, Investment Risk Governance Consultant and Author