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:
- immediate reduction of risk,
- use of an overlay portfolio, and
- 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.