In a survey co-sponsored by Pension Governance
, the RiskMetrics Group
and Ulysses Partners, institutional investors expressed concern about a variety of issues, including:
1. Fiduciary breach litigation
3. Asset allocation mix
4. Investment return assumptions
5. Realized investment returns
6. Investment risk
In excess of fifty percent of respondents said they would like to know more about risk measurement and risk management. That makes sense, given survey results that point to beta, duration and, in the case of derivatives, notional principal amount, as favored ways to track position limits. As explained in great detail in Risk Management for Pensions, Endowments and Foundations
, care must be taken to properly interpret these numbers, understand their strengths and limitations and undertake a comprehensive analysis of risk. Only twelve percent of respondents declared Value of Risk as a way to track position limits. Seventy-nine percent of respondents said that they do not currently use risk budgeting.
Interestingly, forty-six percent of respondents affirmed the use of more than ten money managers. No one answered "yes" to the question: "Do you use zero money managers?" The message? Institutional investors must make sure that the risk and valuation dialogue with external managers is comprehensive and clear. Outsourcing does not absolve fiduciaries of their oversight duties.
Seventy-five percent of respondents answered that the primary responsibility for making strategic risk management decisions rests with a committee. Only two percent answered that consultants or external money managers play this role. Arguably fiduciary education is critical for all committee members who collectively decide on all things risk. (As an aside, committee decisions should reflect analysis by all members rather than having some individuals passively accept the recommendations of one or two "leaders". The author is not an attorney. Fiduciaries should seek legal counsel for advice regarding relevant duties.)
Several results merit special comment.
More than ninety percent of institutional investors with assets in excess of $1 billion said that they know the amount of leverage being used by external money managers. At the same time, they expressed concern about risk management and admitted to using only a handful of risk measurements. Additional research is required to get behind these seemingly contradictory answers.
More than sixty percent of institutional investors with assets in excess of $5 billion cite the use of custodians as providers of "independent" valuation numbers. Only forty percent of investors with assets between $1 and $5 billion use custodians for this job. As institutions gravitate towards assets for which there is no ready public market or for which public market trading occurs infrequently, contacting qualified appraisers
is worth investigating. Valuation disputes often end up in arbitration, litigation or regulatory enforcement actions and more than a few experts have been disqualified for lack of specialized training. Forty-eight percent of respondents claimed a concern about how hedge fund assets are valued.
For interested readers, click here
to read "Hedge Fund Valuation: What Pension Fiduciaries Need to Know". Click here
to read "Asset Valuation: Not a Trivial Pursuit."
Sixty-two percent of respondents confirmed that derivatives are permitted. Worry about the risk associated with derivative use, inadequate systems to monitor and manage risk and lack of familiarity or experience with derivatives showed up most often as the reasons for prohibiting their use. Seventy percent of users cited the use of equity and fixed income derivatives. When asked about instrument categories, sixty-three percent cited the use of futures contracts, fifty percent cited the use of interest rate swaps and forty some percent checked off credit derivatives and currency swaps. About thirty percent of respondents cited the use of options, both exchange-traded and over-the-counter.
Seventy-seven percent of people who completed the survey said that they "feel that institutional investor fiduciaries are more vulnerable to being sued in the aftermath of recent corporate, government and non-profit scandals."
This begs some important questions.
1. What are fiduciaries doing to better protect themselves from allegations of breach of duty?
2. Are investment committee members being recruited, retained and compensated on the basis of their investment knowledge and experience? If not, do they plan to introduce educational and experiential requirements soon? If not, why not?
3. Do fiduciaries respond best to the carrot or the stick approach? If the latter, will an increase in litigation result in better governance? If not, what will prompt organizations in need of improvement to do a better job?
4. How will pension reform and new accounting rules affect the investment risk strategies adopted by public and private funds? (The expectation is that derivatives and related risk management strategies will climb to the top of the MUST DO list in response to anticipated reforms and new rules.)
5. How are fiduciaries carrying out their duties with respect to properly analyzing non-traditional instruments and strategies?
The development of follow-up surveys is underway. Contact Dr. Susan M. Mangiero
, CFA, Accredited Valuation Analyst and certified Financial Risk Manager (FRM) for more information.