The 3 rd Younger Members Convention

1. The 3rd Younger Members Convention Innovative Risk Management 29-30 November 2004, The Chesford Grange Hotel, Kenilworth Duncan Squire

2. Agenda • 1 Introduction • 2 The Meaning of Risk • 3 Risk for Individuals • 4 Dealing with Risk • 5 Types of Innovation • 6 Implications for Individuals • 7 Conclusion

3. Millions of individuals will have to deal with risk management issues as they plan for their retirement. The decline of the final salary pension scheme and the erosion of value of the state pension mean that it has become increasingly vital that individuals find a way, either personally or via “experts”, to manage their own pension portfolios. Even if an individual will probably have enough in assets to meet their future liabilities, there will usually be uncertainty around this central expectation. It is no easy task to manage this risk, given the variability of investment returns from year-to-year, the proliferation of products in which savings can be invested, the long time horizons involved, and unpredictable longevity. This essay looks at the role that innovations in risk management can play in helping individuals to piece together their personal financial jigsaw. Introduction

4. Different people understand different things by “risk”. In my view, risk relates to the possibility of an outcome that disappoints by not meeting objectives. This possibility arises from the interaction of (1) situations that we face, or are “exposed” to, and (2) chance, the variability of outcomes. Risk is not necessarily something to be avoided altogether. The saying “Nothing ventured, nothing gained” suggests that risk may need to be taken in order to achieve a favourable result. The trade-off between risk and return is widely acknowledged, although often hard to quantify. Exhibit: Risk-return trade-off A common distinction is between risk management and risk control. Risk management is a frequent, necessary activity that may act as a brake on the fundamental return-seeking activity. Risk control is a framework that aims to protect a business from adverse events so that the return-seeking activity can continue. Most professional portfolio managers use a range of risk management techniques while operating within a process that includes risk controls. The Meaning of Risk

5. Risk-return trade-off

6. Before focusing on financial risk, let us identify some risks that we face as individuals, and how we deal with them. Risk arises from uncertainty about timing of death, health problems, accidents, crime, terrorism, job loss, market collapse, inflation and tax policy. We need to decide which are most important, which can be avoided, and whether there any offsets. For example, I could reduce my personal risk from terrorism by not travelling into London, but then my job would be in jeopardy. Obtaining a professional qualification might be a way to reduce career risk. Installing burglar alarms and smoke detectors are a way to protect ourselves and our homes. We can insure against many risks, but too much spending on insurance might erode disposable income, savings and potential future wealth. We also rely on others to manage some risks for us, such as the government for health care, social security and defence, or an employer for health and life insurance. Many risks will be left to chance, a policy of “self-insurance”, which might be sensible, particularly as no initial premium is payable. However, in risk management parlance, it is important that risks are both “intentional” and “appropriate” for the people who bear them. Let us focus on the case of an individual with a pool of financial assets, that may include a DC pension pot. The pool, topped up by regular and occasional inflows, is required to pay for future emergencies, large expenses, retirement, and perhaps bequests to the next generation. The individual should be confident that the investment strategy is appropriate for his objectives, should know where the uncertainties lie – e.g. in the assumptions about returns, or in the projected outgoings – and should understand the rationale for the structure of the portfolio. This requires knowledge of concepts from finance as well as risk management – in particular expected return, probability, volatility and diversification. The individual who does not have this at his fingertips may need help from financial advisers or wealth managers who do. If the portfolio is invested in pooled funds such as unit trusts, their managers will rely on the major innovations in risk management, and in turn will invest in businesses and institutions that are active users of risk management techniques. Think of the 45-year old dentist investing 10% of her wealth in a diversified corporate bond fund that invests 3% of its assets in the debt of a building society that buys swaptions from an investment bank to hedge the interest risk on its fixed rate loans to individuals, including dentists. What can the dentist learn from the activities of the fund manager and the swaptions trader, not to mention the actuary and consultant who advise the managers of the dentists’ defined benefit scheme, if it exists? This essay contrasts how these experts deal with risk, before returning to discuss what an innovative risk management framework for the individual might look like. Risk for Individuals

7. Risks to be managed

8. Risk controls for a bond, equity or balanced portfolio manager, aiming to beat an index benchmark, may include: information in the client agreement such as benchmark, performance objectives, limits on number and size of positions, and whether or not derivatives can be used; daily checks on portfolio structure by the compliance department, independent analysis by the portfolio risk team, and monitoring by the Chief Investment Officer. Risk management may include: looking each day or week at the sizes of bets on stocks or sectors, taking profits on winning positions and cutting losses; using forward FX contracts to reduce currency volatility, buying index futures in anticipation of cash inflows; rebalancing the portfolio to align its expected beta and average duration with the economist’s new interest rate forecasts after a Greenspan testimony. Important past innovations are being used here. Duration is a concept which originated in the actuarial field and has been modified to give the most widely used indicator of interest rate sensitivity. Beta is a concept from modern portfolio theory associated with the distinction between diversifiable unsystematic risk and undiversifiable systematic risk that must be rewarded. Portfolios will typically be analysed in a sophisticated software package that shows concentrations of risk from many relevant angles, such as how much in high beta stocks, small caps or multinationals. Dealing with Risk…1

9. Concentrations of risk Portfolio Style Skyline 1.2 1.0 1.0 0.8 0.8 0.6 0.6 0.4 0.4 0.3 0.2 0.2 0.1 0.2 0.1 Style Tilt 0.0 -0.2 -0.1 -0.1 -0.2 -0.4 -0.4 -0.4 -0.6 -0.5 -0.5 -0.6 -0.8 -0.7 -1.0 Debt/Equity Market Beta Market Cap EBITDA to EV Income/Sales IBES 1Yr Rev Book to Price Foreign Sales IBES Div Yld C'Flow Yield Rtn on Equity Momentum ST Momentum MT IBES Engs Yld IBES 12Mth Gr IBES Sales Yld Earnings Growth IBES Sales 12m Gr Style Factors Source: Style Research

10. Risk controls for an interest rate option trader will typically include: Value-at-Risk (VaR) limit, e.g. no more than $5 million loss over 1-day with 95% confidence; a limit on exposure to parallel yield curve shifts and individual maturity buckets, and a maximum sensitivity to volatility; counterparty risk limits set by the Credit department. Limits will probably be set for the individual trader, department, business and overall firm. Risk management will involve using derivatives such as FRAs, swaps and interest rate and bond futures to hedge risk; close monitoring of yield spreads and implied volatilities for different instruments. Time horizon is an important difference: the trader and the investment bank will have a daily P&L account; the portfolio manager may only see monthly performance returns. The defined benefit scheme has longer-term objectives relating to the work- and life-cycle of members, more akin to those of individuals. In this case it is hard to distinguish between risk control and risk management. The trustees use projections of future liabilities and contributions to determine a strategic asset allocation with a high probability of achieving the scheme’s objectives, and also choose bond investments with a duration that is consistent with the liability profile. Asset managers are selected and their processes and results are monitored: for example, an equity manager may have to report each month that the predictive tracking error from a specified risk model is within a 3-6% range. The asset allocation process may include evaluations of “new” asset classes such as inflation-linked bonds, high yield bonds, hedge funds and private equity. For example, high yield bonds are a hybrid instrument with both equity-like and bond-like characteristics, so they could be useful for diversifying a bond portfolio while adding to potential excess return. The growth of this asset class has been facilitated by new techniques for managing the complex non-linear payoffs – little upside, big downside risk – that arise from credit events. Dealing with Risk…2

11. There have been at least three different types of innovations in risk management, some of which have already been mentioned. Firstly, analytical innovation can allow superior identification of offsets within portfolios. The broader the scope of the analysis, the more likely that offsetting positions – as well as similar positions – will be found. The more offsets, the better diversified a portfolio is, and the lower the amount of residual risk that remains to be managed. VaR systems like RiskMetrics provide this kind of aggregated view of risk, which is mainly based on correlation assumptions. Second, product innovation can deliver efficient ways of hedging risk in individual positions or in portfolios. This is demonstrated by the explosive growth of futures, options, swaps and, most recently, credit derivatives. Derivatives are an ever-evolving class of instruments that allow risk in particular products to be transferred to a more willing and/or able bearer of risk. Options have become much better understood and widely used since the Black-Scholes breakthrough in the early 1970s. Analytical and product innovations are usually linked: for example, the number of equity index futures contracts required to hedge an equity portfolio depends on its weighted average beta to the index. Third, technological change – faster computers, new algorithms such as Monte Carlo simulation – is continually allowing quicker calculation of the overall risk position of a portfolio. This is most useful to risk managers with shorter time horizons, but is also beneficial for large asset management companies with many portfolios to analyse. For the individual, the internet gives ready access to financial market data and web sites with analytical tools. Types of Innovation

12. These innovations are all directly or indirectly useful to an individual investor. Risk controls and risk management by professionals should, in most case, give investors the benefit of a more predictable return profile with fewer nasty surprises. However, there is no guarantee of continuous success, even if leading innovators are managing portfolios, as shown by the example of Long Term Capital Management in 1998. Forecasts of risk and return can also turn out to be very wrong, as illustrated by the losses made by balanced funds with high equity weights in 2000. Many pension funds chose a very unfortunate asset allocation on the basis of historic covariance relationships that subsequently broke down. Recent years have reminded us that international diversification does not work when it is most needed, namely in market crashes. The bear market of 2000-3 has been partly responsible for a new trend, a kind of “back to basics” in asset management that is very relevant to individual investors. Disillusionment with the performance of volatile indices has led to renewed interest in “absolute return” mandates that aim to generate returns in excess of cash yields or price inflation. In an absolute sense, a portfolio’s risk depends simply on weights, volatilities and correlations for the component assets. This basic approach, which is not innovative, could be used by individual investors in assessing the overall risk in their portfolios. The goal is to sketch out the probability distribution for a portfolio’s return over the relevant time horizon (see Chart), and to check that there is an acceptable chance of meeting objectives, such as to avoid loss, beat inflation or fund retirement. Implications for Individuals

13. Probability distribution of portfolio return Simulated return over 5 years with 7% expected return p.a., 11% volatility Probability 10% chance of loss -50 0 100 150 Return Mean = 41

14. Market data Source: Datastream

15. Returns Source: Datastream

16. Changing risk patterns Weekly Returns, 1 year to 16/6/2000 Weekly Returns, 1 year to 18/6/2004 3.0% 3.0% 2 R = 0.1195 2 R = 0.0674 2.0% 2.0% 1.0% 1.0% Gilts Gilts 0.0% 0.0% -1.0% -1.0% -2.0% -2.0% -3.0% -3.0% -7.0% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% 7.0% -7.0% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% 7.0% UK Equities UK Equities Source: Datastream

17. Volatility and correlation Source: Datastream

18. Equity diversification: least effective when most needed A B Source: Datastream

19. Equity diversification: least effective when most needed B A Source: Datastream

20. What individuals need most is not innovation in concepts so much as innovation in education – teaching people about risk, and helping them to apply the ideas. Examples would include financial literacy programs (mandatory statistics in school?) and user-friendly web-based tools that demystify correlation matrices, show risk/return expectations for different asset classes, but also include clearly worded caveats about relying too much on historic data. Individuals will benefit indirectly from future innovation by rocket scientists in risk management theory and financial products, but equally significant could be the payoffs from innovation in how existing risk management ideas are explained and delivered. We all need to learn to be good risk managers now. Conclusions