Certain financial institutions in Asia are seeking more sophisticated approaches to their risk budgeting as they assess how portfolio risk could radically change in 2017. That is leading some to put a greater focus on private market investments – and how to assess the risk around them.

Risk budgeting, which involves tracking and calculating risk across a portfolio of funds and asset classes, is the best means to ensure a single-portfolio focus for the whole investment team, rather than simply meeting an asset class quota, wrote Roland Winn, senior investment strategist at New Zealand Super Fund, in a paper issued last week. 

“Risk budgets help us assign capital judiciously,” he said, “allowing investment professionals who are deeply familiar with investment opportunities to be closely involved in decision-making.”

Within the overall active risk budget for NZ Super, investment opportunities with similar underlying drivers are grouped together in baskets, with the investment opportunities in each basket having similar risk characteristics, such as diversifiers, market pricing or asset pricing.

While NZ Super remains heavily weighted to growth assets, in keeping with its long investment horizon, “most investment opportunities are currently sized below their risk budget levels" said Winn (pictured left).

That is because a correction in global equity markets is expected this year, however short term, and some major markets are still unwinding from the effects of financial repression, he added.

This unwinding will drive assets in different directions, requiring a different portfolio management framework, according to Daniel Gerard, head of advisory solutions for Asia Pacific at State Street.

Given the expected "regime change", it is not enough to base assumptions on historical covariances, he said. The way equities and bonds perform relative to each other can also be very different during policy shocks compared with other periods.

"If we expect a 'change' in government policy, yet still expect strong concerted government policies, then estimating risk from history becomes very hard," noted Gerard. "The asset class [fixed income] that was supposed to be the safest allocation in the portfolio could become the riskiest with the least upside potential."

Private draw

That is at least partly why investors are looking for a further shift into private markets. The non-correlated and long-term nature of such investments appeals to institutions with the flexibility to move in this direction, who can also utilise specialist advisers.

"With low yields and potential policy shocks on the horizon, asset owners continue to seek yield alternatives to help protect against the change," Gerard said. "We have seen a number of sovereign wealth funds discuss changing preferences for infrastructure, which makes a lot of sense. These private market investments can be cashflow-positive much more quickly than private equity and can be seen to have less correlation to existing asset classes."

Yet private market investment brings with it a very different set of risk budget challenges. Although some Asian state funds are working hard to integrate different risk systems, Gerard told AsianInvestor that the reality is “we have a long way to go before we understand private market risk better.”

The starting point for sovereign investors, for example, when thinking about private markets investment, is 'how do we know that it works?', he said. "If they are getting idiosyncratic risk or some unique exposure, how do they measure that?"

Nonetheless, some asset owners are taking up the challenge themselves and Gerard cited AustralianSuper as an example of an institution working hard to internalise mandates. “It is a large fund that is growing quickly through acquisition as well as internal growth. They are doing it at a pace that will allow them to understand what worked and how to accelerate those programmes," he said.

The Melbourne-based pension fund showed its maturity as a private markets investor with its A$16.2 billion bid in October, in association with Australian fund house IFM Investors, for a controlling stake in electricity company Ausgrid.

It is not just the asset owners who still have a lot to learn. State Street has a team full of academic advisers.

“We even hired the guy who wrote the textbook on credit portfolio management to think about how to manage private markets risk, and three years down the road we’re still thinking about it," Gerard said. Jeffrey Bohn, author of 'Active Credit Portfolio Management in Practice', joined State Street in 2013 as chief science officer.