Carl Hess, New York-based global practice director at Watson Wyatt Investment Consulting, posed two questions last Friday to an audience of asset managers, funds and consultants. The first (to which only funds were requested to respond) asked: 'How much of your time do you spend on risk management?' The vast majority (84%) said 'not enough', while the remaining 16% said 'about right'. No-one voted for the response 'too much'.
Hess's second question -- 'Please rate the risk framework of large funds in Asia' -- asked the entire audience for its participation. A quarter of them (23%) said 'poor', over half said 'acceptable', 21% said 'good', while only 1% gave the answer 'excellent'.
Commenting on the response to the first question, Hess said: "We tend to agree with you that most funds don't spend enough time on risk management", and that they tend to place greater focus on achieving returns. This is understandable, he added, given that risk is "nebulous, second-order and often not concrete -- in fact, it's a lot harder than just thinking about returns". Moreover, the framework for dealing with risk has been fairly limited to date, meaning it is easier for firms to simply focus on returns.
The traditional risk perspective made "some heroic assumptions", added Hess; firstly, that all risks can be modelled -- "the amount of hubris in that statement is staggering if you think about it". Second, it tended to use history as a guide to what risk could look like in the future -- "but simply extrapolating on the past makes us perhaps doomed to repeat it". Third, there has been a focus on certain metrics that may have focused on one particular aspect of risk but ignored others, such as looking at the likelihood of a loss but forgetting about the magnitude of it.
There are a few key points to bear in mind about how risk management might be improved, said Hess. "One is to review your views on risk," he added. "You want to be taking risk -- that's why we're here. But you want to be taking risk in a smart way." He recommended firms focus on risks they are compensated for, such as the risk of investing in equities or illiquidity risk, and looking at hedging out those they are not compensated for, such as inflation risk or interest rate risk. And if you can't handle the uncompensated risk, added Hess, then don't make the investment.
He went on to outline a concept that Watson Wyatt introduced to its clients this year called the fund dashboard, which helps funds to prioritise important issues in relevant areas -- including risk management -- and to create a clearer decision-making framework. Some clients are using it successfully, said Hess, including one in Hong Kong.