Alternatives and Enterprise Risk

under car hoodMore pension funds are looking at enterprise risk, but when you’re invested in alternatives, it’s harder to incorporate these assets into your analysis, explained Frances Barney, head of global risk solutions consulting—Americas, with BNY Mellon. She was speaking at the Risk Management Conference held in August 2015 in Muskoka, Ontario.

Tools to gauge enterprise risk include stress testing, sensitivity analysis, value at risk (VAR) and exposures. “VAR got a lot of bad press a while ago because it was blamed for the financial crisis,” Barney explained, adding VAR can be dangerous if used badly.

Best practices for pension funds are to look at different definitions of risk and multiple risk models—and “take every conclusion with a grain of salt,” she added.

Incorporating alternatives

But factoring alternative investments—such as private equity, real estate and hedge funds—into enterprise risk analysis is a challenge.

Unlike traditional assets, alternatives don’t have daily price movements and offer little liquidity. And you might have to make a lot of assumptions due to insufficient data, noted Barney.

Lack of transparency from hedge fund managers can be an issue. “In practice, they often won’t give permission to an investor to see the underlying holdings…it’s not really enough to do the kind of ex-ante risk analysis that will lead to meaningful results,” Barney explained, adding, “Use the best available detail where you can get it.”

The data on alternatives that’s available to investors comes at different levels: top level (i.e., line item proxy of the market index representing the best match with the investment); mid-level (e.g., exposure summaries by region/country, sector/ industry, etc.) or, ideally, detailed holdings. It’s best to get the detailed holdings, said Barney. Although managers might not be willing to disclose them to investors, they often will make holdings available to a risk provider with non-disclosure agreements. In that case, the risk provider may be able to share calculated exposure information with the investor.

It’s also important to understand that having different levels of data (e.g., exposures versus actual holdings) can lead to the appearance of different exposures—and, therefore, to a potentially different conclusion about the overall risk of the portfolio, she added.

To get a clearer picture of enterprise risk, Barney advises investors to understand the impact of proxies on risk management analysis, do risk analysis both with and without illiquid assets, and recognize that there are investment structures—e.g., dedicated managed accounts—that offer more transparency and control.

And investors shouldn’t be afraid to ask for more data to improve the risk analysis. The best time to do it is when you’re first making an allocation to a new alternative manager, since that’s when you have the most leverage, Barney explained. “You do have the power. Use your power.”