Four Risk Experts on What Solid Risk Management Looks Like
Solid risk management—including risk controls, policies, and oversight—is only becoming more and more crucial to due diligence, manager research, and certainly, portfolio construction professionals. When things are going fine, no one’s asking about risk protocols, but the minute there’s a problem, a harsh spotlight comes on. This is why a robust, well-led risk management operation is always running in the background, vigilant and proactive.
The following panel of risk leaders graciously addressed the research and due diligence community to share their respective views on what solid risk management looks like. In the discussion, Jae Yoon moderated, while Michael Welhoelter represented the risk lens on equities, Ping Jiang spoke for fixed income, and Rajiv Mallick represented the alternatives asset class. What follows is a quick distillation of their dynamic and thought-provoking panel.
- Jae Yoon, CIO, CFA, Senior Managing Director, Strategic Asset Allocation & Solutions (JY)
- Michael Welhoelter, CFA, Managing Director, Head of Quantitative Research & Risk Management, Epoch Investment Partners (MW)
- Ping Jiang, Managing Director, Head of NYLIM Investment Consulting Group (PJ)
- Rajiv Mallick, Senior Risk Manager, APG Asset Management (RM)
“You want to see the risk function clearly influencing the portfolio contruction process. You want to know people have the discipline, backbone, and experience to do the job. Risk management can’t be a decoration or an afterthought.” – Ping Jiang
JY: How do you view or define risk?
- MW: I view risk as the probability of not achieving an expected outcome. As an active manager, your job is to take risk where you have skill. Where you don’t think you have skill, you need to take a deeper look at how you’ll mitigate risk. It comes down to focus and efficiency. The idea is to get our skill into a portfolio as efficiently as possible, while managing the risk.
- PJ: In the investment consulting group, from a NYLIM perspective, our most important mandate is investment risk oversight. We follow risk guidelines, taking care to ensure they’re in line with portfolio objectives. The risk team sees daily holdings and performance information for ex ante and ex post risk monitoring.
- RM: In the alts universe, you want to add a layer of operational risk oversight. We want to understand, for example, how much of your money market account is in asset-backed commercial paper (ABCP)? What kind of prime broker relationships do you have? Do you have more than one? How strong are those relationships? We look at when managers change their positions and consider how that will impact the overall portfolio. We also evaluate whether the manager is providing appropriate access to areas of the overall market that are evolving. Are they able to wind down from anything with the characteristics of a possible bubble?
JY: How do you measure risk?
- MW: For a forward-looking perspective, we use the Barra risk models to see how well positioned the portfolio is for the future. We also look historically. We might look at performance and how risks were taken, and whether we were rewarded for them. Were there unusual outcomes? Let’s understand why things that worked did. And why things that did not work, didn’t.
- PJ: Different products require different means of evaluation. Benchmark-sensitive products call for an evaluation of tracking error. Leveraged products call our attention to tail risk events. Benchmark-agnostic products have us evaluating total risk versus a reference benchmark. We also note the structure of risk. For example, for an unconstrained bond product we’ll look broadly at rate and credit risks. We’ll also follow the dynamic of the correlation between the two to arrive at a panoramic view of risk.
- RM: Alts are mostly a benchmark-agnostic asset class. The general impression is that an alts allocation should contribute to alpha, regardless of the economy. So, the biggest focus is on a manager’s ability to mitigate downside—the distressed beta. If they’ve taken big bets, have they been compensated on the other side? We also want to be convinced that what a manager sees as an opportunity in an area of the market is actually viable. We look at the thesis, the philosophy, and at how they view their distressed beta.
JY: What kinds of tools do you use to manage risk?
- MW: I mentioned that we use Barra risk models. The benefits of using a third-party risk model is that it’s widely used, well-vetted, and tested by other people. It also makes it easier to have a conversation with clients and consultants who use the same tool. The downside is that an off-the-shelf risk model doesn’t always fully capture the risks you might be taking in your portfolio. We’d love to focus on free cash flow yield and free cash flow growth. We have begun to put a model together to reflect that, but the Barra models are very useful, and allow us to communicate effectively with others.
- PJ: I started my risk career building risk metrics and Barra-type models, so when I went into the practice side, I was able to appreciate the pros and cons of using these models. In terms of fixed income tools, we recently assessed the six top-tier vendors, and determined that the best fit for us on the fixed-income side is a combination of MSCI’s risk managers, Bloomberg and Aladdin. We use each of them for different products, depending on which one best captures the risk characteristics.
- RM: MSCI gives us position-level information on a lot of our managers. We can see the composition of risk and drawdowns. We also estimate certain stats ourselves. We focus a lot on systemic beta. Mostly, you find that the equity beta of a hedge fund is generally non-existent, but then it spikes up. We look at beta in a normal scenario, in a distressed scenario, and when things are going well. We don’t want to rely on VaR. We want to stress the positions, and take insights from that. We focus on how the risk evolves in the portfolio over time. We want to see the risk fall within limits, and when it doesn’t, you raise questions with the manager.
JY: When do red flags go up in your risk evaluations?
- MW: Whatever we observe should be consistent with the philosophy, objectives, etc., and when it’s not, it’s a great opportunity for a conversation with the PM. We get concerned, too, when tracking error goes down because we’re active managers. We’re paid to take appropriate risks, and we have conversations around that, when needed.
- PJ: Both outsized gains or losses trigger an evaluation of whether we’re taking on the right amount of risk. Other times, I also see red flags within trends. If the trend does not fit into the PM’s initial trial, we look at that and figure out if we need to take additional measures. From a market perspective, we can see complacency or consensus view on a situation. For us, this calls for scenario analysis. We look at a full set of possibilities.
- RM: Our investment management agreement lays out many risk parameters. Soft breaches will raise questions of the PM, because we’ll want to know the thesis behind the change in position. We look at how the market is evolving: bank debt issuance, high yield, ABS. If anything starts to look like a bubble, you take a closer look. Red flags are a good thing because they start important conversations.
JY: How does the risk role influence the PM role most directly?
- MW: At the core, we’re paid to undertake two key activities: asset selection and portfolio construction. I am here to support the best possible portfolio construction, and the ability to collaborate makes that possible. When there are stresses in the portfolio or the market, the nature of our ongoing relationships makes it as easy for managers to come to me as it is for me to go to them, when concerns arise. We’re problem solving together. This culture and ability to collaborate pervade the firm. The managers come to me as the risk person. It’s not only me going to them. The culture pervades the whole firm.
- PJ: It’s crucial to communicate guideline expectations up front, and for risk managers to have the backbone to stick to those guidelines. Building trust is about consistent, two-way communication. My own approach has been to offer PMs a reliable combination of hard data with common sense, and to gain PM confidence in my opinions as a risk leader over time.
- RM: Data visualization helps a lot in the work of getting a front office or CIO or PM to buy into your analysis. As a risk manager, your job is to look at and interpret the hard numbers, and generate a substantiated opinion. But, your job doesn’t end there. You then need to distill it into a form that can be used—and understood—by other parts of the organization.
JY: What’s your approach to facing challenges in risk management?
- MW: Learn from any air pockets you encounter. To the extent that you can, build processes around managing that type of air pocket going forward, so you can better manage it next time.
- PJ: Investors can sometimes expect very high returns without realizing the risk profile of those kinds of investments. The world is full of products that are too good to be true. For our part, we want all stakeholders to understand the risks inherent in investing. So, we humbly request to see disclosures they show their own investors.
- RM: I wish we had a way to see trouble ahead the way the maps on your smartphone can help you avoid traffic. We’ll keep trying for a way to see the future.
JY: What should a due diligence analyst be sure to ask a risk analyst?
- MW: On the risk reports, show me the elements that demonstrate the portfolio manager is doing what they say they are. What do you do when something goes wrong? Pilots use an acronym: ANC (aviate, navigate, and communicate). For me, it’s Communicate with the PMs (what’s going on?). Next is to Aviate (are they flying the plane as I expect?). If there’s an issue with the portfolio that I can help them get to a better position, that’s where the “N” for Navigate comes in. I’ll add a last one: Investigate. Once we have everything in place, let’s figure out what happened, and how we can better prepare in the future.
- PJ: Is there a robust risk process in place? How does info flow from the risk side to the PM side? How does the portfolio construction process use the info from the risk process? Are the right people on the right job? You want to know people have the discipline, backbone, and experience to do the job. You want to see the risk function clearly influencing the portfolio construction process. Risk management can’t be a decoration or an afterthought.
- RM: What part of this risk report is important to you? How did the PM handle ‘07–’08? How did the GFC change your models/methodology? How would you fare if those conditions occurred today? Get a feel for the portfolio, and a sense of how much risk analysis has gone into directing what they’re doing today.
New York Life Investment Management LLC engages the services of Epoch Investment Partners, Inc., an unaffiliated, federally registered advisor, to subadvise several mutual funds.
APG Asset Management is not affiliated with New York Life Investment Management.
SAS and ICG are business units/divisions of New York Life Investment Management.
The opinions expressed are those of each respective panel participant, and are subject to change. There is no guarantee that any forecast made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment.
New York Life Investment Management LLC engages the services of federally registered advisors.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.