During the global financial crisis, the Alaska Permanent Fund Corp. implemented a new governance report to bring together all elements of its investment portfolio and communicate risk to the board, says Max Giolitti, the fund’s former head of asset allocation and risk, and current chief risk officer at Verus Investments.
The work began by educating the board on risk concepts and factors, he notes. “If you give me a corporate bond and I’m a factor person, I’m going to take the rates part and the credit part and put them separately. I’ll take the rates part and combine it with the rates from my treasury and I’ll take the credit part and combine it with my equities. It’s very natural. Well, if I’m not a factor person, I take this corporate bond and I say, ‘OK, which bucket do I put it in?’ . . . You have a lot of decisions that are harder to make.”
The governance report maps out the risks at the total portfolio level and by factor. It also uses a system of green, red and yellow zones to provide a big picture view of the entire portfolio. For example, at the Alaska Permanent Fund, the report was set up so the chief investment officer is responsible if the risk is in the green zone, if the total portfolio risk is in the yellow zone it should be flagged to the executive director and if it’s in the red zone, it should be flagged to the board, he said. “Basically, the idea is that [for] a lot of the day-to-day activities, you don’t really require the board. It is a waste of their time to get involved in certain things. So you create a hierarchy.”
Board members should be spending their time on bigger decisions instead of being involved in the minutia, notes Giolitti. “I have this metaphor of the thermostat. You want the board setting the thermostat level. But on the other hand, you don’t want them worrying about the wires that go behind the thermostat and how they connect to the heater or the air conditioner. If they start worrying about that stuff, then they don’t do their job, which is to set the level. So if you free them from the burden of doing that, then they’ll be able to focus on what they need to do.”
The governance report also aims to help the board see the overall level of risk in the portfolio so they can then direct the staff to lower or raise the overall risk if needed.
However, just because something is in the red zone, it doesn’t mean action is required. Rather, it’s a flag for discussion, Giolitti adds. “It’s like your car dashboard. If you’re going at 100 kilometres an hour, is that good or bad? Well, it depends. If you’re rushing to the hospital because somebody’s sick, it’s a good thing. If you’re near a school, it’s a terrible thing. So you can’t tell whether what the dashboard says is good or bad. That’s where humans come in.”
When rolling out the governance report for a board, it’s important to communicate extensively, he notes. And pension plan sponsors should use the system continually, not just when a crisis hits. “During normal time frames, you set up a framework like this, you see how it operates, you start getting accustomed to the variations because . . . when the crisis hits you start getting extreme metrics.”
At the Alaska Permanent Fund, the implementation of the new approach to risk monitoring has been a success, says Giolitti, noting it’s moved the risk session to the start of board meetings and still uses the system. He’s also worked with other funds since to implement similar processes.