Beyond Risk Budgeting

road narrows signRisk budgeting is important for pension funds, but they need to let the risk budget fluctuate and focus on when to deploy risk capital. That was a key message of Eduoard Senechal, senior risk capital analyst, dynamic allocation strategies team, with William Blair & Company, L.L.C.

For example, from 2005 to 2007—a period of low volatility and low reward—investors who stretched themselves wound up having to sell the securities at lower prices. Unlike credit card holders who might simply “max out” during bad economic times like these, pension funds should make sure that they’ll be able to borrow if they need to.

“When there is a good economic time, you shouldn’t get close to the limit,” Senechal said, adding that it’s important to be able to deploy risk capital when it matters the most.

It’s easy to get stuck in a vicious cycle, he explained. When a market sell-off occurs, it produces increasing volatility, risk models indicate higher portfolio risk, and investors often reduce their exposures to stay within the risk budget.

However, he said, going against this cycle reduces correlation with the market as well as with other investor strategies, thereby decreasing endogenous risk (i.e., risk caused or produced by factors within the system).

According to Senechal, it makes sense to increase risk when the potential Sharpe ratio is high (i.e., when there are more opportunities) and decrease risk when the Sharpe ratio is low (when there are fewer opportunities). But, in order to truly benefit from long-term investment opportunities, “it’s really at the point when it’s least intuitive to take risk that we’re going to take risk,” he said, adding, “Risk is rewarded over time, but it’s not rewarded all of the time.”

The objective is to invest in the right asset class at the right time, he said, quoting Warren Buffet: “We simply attempt to be fearful when others are greedy and to be greedy when others are fearful.”

Alyssa Hodder is editor, Benefits Canada.