Risk should be judged by looking through the windscreen, not the rearview mirror
Risk is defined and calculated in any number of ways, but the fund management definition typically relates to volatility. ‘Minimum risk’ must always be defined as the allocation of assets considered most likely to achieve a portfolio’s objectives; and for long-term planning, volatility is of limited relevance. The fund manager’s job is simple: it is to achieve agreed objectives while exposing portfolio assets to as little risk as possible. Here, the definition of risk is the extent of the departure from the minimum risk strategic allocation in the pursuit of higher returns.
I started work after leaving university in the late 1970s, managing corporate pension fund assets. Our team managed many billions of pounds and dollar assets for UK and US companies’ asset pools set aside to fund future benefits to retired employees. In this case, one might think the definitions of minimum risk allocations were surely those judged to be the most likely to provide sufficient funds to meet these future pension liabilities - a simple and straightforward objective? No, this risk definition bore little relation to industry’s asset allocation policies, which were exclusively designed to minimise the fund manager’s business risk and not to match their individual client’s liabilities.
In the 1980s we employed two independent performance measurement services, and both provided quarterly return measurements compared to the median fund on their service, together with the median fund’s asset allocation. So, our benchmark was the median of all fund managers and of all funds using their service, not the specific and individual liability profiles of each pension fund. If we beat the median fund we attracted new business opportunities, if we failed, we risked losing clients.
One service covered many of the county council funds which carried higher weightings in direct property investments. So, the ‘minimum risk’ allocation for funds measured on this platform contained 11% in property, while on the alternative service, the median fund’s property weighting was less than 4%. As a result, two identical funds could have entirely different ‘minimum risk’ allocations according to which service they employed to measure their performance!
Nearly half a century later and following advances in risk analysis, surely this situation must have improved? Not so. Within the pension fund management world, balanced mandates that involve one manager taking control of both asset allocation and stock selection have typically given way to core indexation and satellite specialist managers tasked with generating ‘alpha’ - excess performance through active individual stock selections.
I recently attended a meeting to discuss the silos of risk allocations for various client profiles. Fund managers reflect private customers’ individual circumstances before allocating their investments between asset categories, a decision that has historically accounted for over 90% of returns. In practise, fund managers place clients into different risk ‘silos’ from low risk through to the more adventurous and long-term clients who can ignore short term volatility. This ticks the regulatory box while allowing managers to manage hundreds of client portfolios in the exact same way, using automatic computer-generated analysis to ensure all customers in the same risk silo hold the same investments and perform in line.
I must now revert to the title of this diatribe. Measurements of risk typically relate to historical performance and work on the assumption that history will continually repeat itself. If ever there was a time when the rear-view mirror generates inappropriate conclusions, this is it. A glance through the windscreen will provide much evidence that the economic and investment landscape is changing rapidly. However, fund managers who reflect these changes within their client portfolio allocations are taking serious business risk, just as the pension managers and trustees in the examples that I described above.
I will use one outdated and dangerous assumption to make my point. I return to the meeting that I alluded to in the previous paragraph. Both the minimum and medium risk silos contained bond allocations in excess of 30%. This on the basis that bonds mitigate portfolio risk. Whether or not I am right that in fearing that a period of monetary debasement renders monetary assets the highest risk asset of all for long term portfolios, this is not what is of relevance here. The justification for this bond allocation has nothing to do with the pursuit of higher risk-adjusted returns, it is the fear of departing from the average competing product.
The lessons are clear: fund managers wishing to depart from outdated assumptions governed by history need to make the choice now to reflect their judgement of the changing sources of risk to adjust their risk assumptions and the optimal asset allocations, before it is too late to rescue the long-suffering private investor from what is coming down the track.
About the author
Jo Welman had a career in the City spanning 45 years and worked in a wide variety of financial sectors. After graduating from Exeter University in 1979 with a degree in economics, Jo spent ten years at Baring Asset Management where he managed a range of UK and US pension funds and unit trusts, investing across multiple sectors including bonds, international equities, commercial and residential property and private equity.
In 1989 Jo became Managing Director of merchant bank Rea Brothers’ institutional and private wealth investment management division. Over the following decade Jo launched a series of specialist investment trusts and funds in a variety of industry and property sectors, before forming a joint venture with reinsurance broker Benfields (now Aon Benfield) and raising one of the first limited liability corporate capital vehicles for the Lloyds insurance market in 1993. As part of his long-standing involvement in the insurance industry, Jo co-founded the Benfield Re-Insurance Investment Trust plc (Brit) in 1995. Following the sale of Rea to Close Brothers in 1999 Jo became Chairman of Brit Insurance Holdings Plc and in 2001, in partnership with Brit and Benfields, he co- founded specialist asset management firm, EPIC Investment Partners (EPIC).
Jo continues to provide corporate finance and investment advice to entrepreneurs and private investors. He sits on the board as a non- executive director of ARK Syndicate Underwriting
“Feet up by the pool”
Jo does not receive any remuneration for his EPIC commentary. Instead, EPIC is pleased to promote the latest edition of his book “Feet up by the pool”.
Profits from sales of the book go to The Money Charity, a charity that shares Jo’s objective to help fill in some of the worrying gaps in the school curriculum. These omissions leave many young adults lacking in the financial awareness that they need to survive in a world where they will rely on their own savings if they are ever to stop working. Even if they earn the right to a full State Pension, today this amount hardly covers council tax and utility bills, and so they need to save and build up a sum of capital amounting to around twenty times their desired retirement income. A frightening number.
As Jo eloquently says, “If we can do our bit to raise awareness of the impending UK saving and pensions crisis, the exercise will have been worthwhile.”