While markets have generally performed well year to date in 2009, the sting of late 2008 through early 2009 remains prominent in many investors’ longer term portfolio valuations. The term ‘systemic risk’ has gained a great deal of attention by regulators and other interested parties as a way of learning from the latest financial crisis with a view to reducing risk in the future.
For simplicity, I define ‘systemic risk’ as the risk of sudden seizure of a financial system such that markets cannot function properly, as opposed to the risk associated with any one component of the collective financial system. The global financial community has finally embraced what pension plans and other institutional investors have been practicing via risk- budgeting all along—the sum of the parts is more important than the pieces.
In my last two articles, (available here and here) I wrote about asset allocation and the un-super-ness of the ‘super fund’. There were not many comments about my asset allocation article, but the super fund article generated many rather candid comments, with roughly half of comments ‘for’ and half ‘against’ the concept of super funds. It will be interesting to see if global efforts to curb systemic risk alter the dominance that asset allocation has historically played in the risk-budgeting process. It will also be interesting to see how the thematic view of an organization’s size in indicating whether an organization is ‘too big to fail’ or ‘too big to succeed’ plays out in terms of the concept of super funds or investment managers in general. I explore these two areas in more detail below.
Most plan sponsors utilize a top-down asset allocation strategy, whereby:
1. an asset allocation decision is made between traditional equities , bonds and alternatives; and
2. a manager structure is then developed to implement the asset allocation strategy, taking into account views towards active and passive management, investment styles, etc.
Inherent in this process is an asset-liability or asset-allocation modeling in order to understand how the asset classes combine and interact with each other at the total plan portfolio level This is fundamentally what academia, politicians, the SEC and many others are trying to apply in the world: setting the aggregate global financial system of banks, insurance companies, etc. in terms of being viewed as a single, overall portfolio.
The big question is how the implementation of any regulatory systemic risk recommendations will impact the historical top-down asset allocation model. More precisely, will asset allocation continue to be the largest determinant of risk and return in a total plan portfolio context, or will it decrease in importance versus the manager structure decision?
It is too early to establish any meaningful analysis, but it will be interesting to see what impact new regulations, for example, on large hedge funds will have on the overall ability of traditional and other alternative managers to find and capture investment opportunities in a globally more transparent universe. No doubt confidentiality conditions will be required such that the ‘regulator’ (I’m not sure who will actually regulate hedge funds) does not publicly announce the hedge funds’ ‘trade secrets’ but it seems unlikely that any secrets will be kept for long from an industry that is so innovative and competitive by nature and driven by compensation.
Another important—and to me a more conceptually interesting—aspect of systemic risk is the impact on our psyche. Historically, human nature has been to find comfort in remaining within the herd and this extends to whether it is the management of plan assets with larger, more established firms, or benchmarking to what most other plans are doing. The basis for following the herd appears to once again be human nature’s tendency to prefer being ‘wrong but wrong with everybody else’ over being ‘wrong and alone’. This all may change with improved understanding of systemic risk.
We have seen this to some extent in practice through recent manager search activity where sponsors are increasingly becoming concerned about the size of their managers or the absence of capacity constraints. The worry is that the manager will get too big to be able to repeat the quality risk-return results that the manager has produced in the past. This is also where the intuitive appeal of the super fund loses some of its lustre as our psyches move towards the view that bigger is neither better nor safer.
From a regulatory perspective, systemic risk analysis will likely take into account long-term risk aspects. This may either favour or damage larger institutions, as seen with Bear Sterns being allowed to fail while AIG being deemed too big and complex to let fail. In Switzerland, two banks comprise almost three-quarters of the financial system, and so the Swiss government is considering limiting the size of any one bank in an effort to mitigate systemic risk in the Swiss banking system. We may see something similar within banking and insurance in general and perhaps even with some investment firms; given the merger and acquisition activity that has produced ‘mega’ investment firms.
Continuing with the regulatory landscape, I appreciate Andrew Lo’s testimony prepared for the U.S. House of Representatives Committee on Oversight and Government Reform in November 2008. Mr. Lo is a professor at MIT’s Sloan School of Management, and something of a real life version of Matt Damon’s character in the movie Good Will Hunting: working through network diagrams, using node theory to explain the interaction of such things as leverage, liquidity, correlation, concentration, sensitivity and connectedness in a financial system, etc. (less the janitorial beginnings, of course).
In his testimony, Mr. Lo emphasized the need for ‘better’ regulation and not more regulation. In particular, he promoted the idea of a “Capital Markets Safety Board” that would be “dedicated to investigating, reporting and archiving the ‘accidents’ of the financial industry.” This approach is quite different than the multiple agencies approach being promoted by the usual suspects of the industry that would no doubt be subject to bureaucracy, meddling, and self-promotion. The CMSB is akin to the U.S.’s National Transportation Safety Board, which is truly independent and has seen its recommendations lead to significant advances in both air travel and highway safety.
A CMSB would be a refreshing approach to regulation, as it follows a principle-based approach instead of an approach based on setting more rules. In addition, it is an approach that is completely aligned with the interests of the end-user with no meddling. We could use this approach in Canada not only to identify gaps and improve the level of transparency between financial system and market participants, but also to provide a ‘champion’ who would be dedicated to the integrity of capital markets.
Peter Arnold leads the Canadian Investment Consulting Practice for Buck Consultants, an ACS Company. He is responsible for the development and delivery of all investment and defined contribution consulting services in Canada.
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