“The CIO is also responsible for identifying qualitative implementation risks, including relevant investment manager business risks, personnel risks, operational risks, and any other risk deemed material to consideration of potential total fund return."1
The above quote highlights five specific risks that chief investment officers (CIO) face on a regular basis. Seems somewhat manageable if it were not for the reality that within those five risks lies countless additional risks institutional investment staffs must address. The article in which this quote appears uses the word “risk” over 70 times in several different contexts — risk management, risk objectives, risk requirements, risk tolerance and risk measurement. Obviously, managing these risks is important but given the widespread areas in which risks can infiltrate, the bigger challenge then becomes identifying these risks.
Failing to identify any of these risks when placing money with an investment manager could result in permanent capital loss, whether through fund failures or forced crystallization of a loss via a sale to fund commitments elsewhere in a portfolio.
With this in mind, it is shocking to see how many proposals seeking new investment advisors focus on performance or risk-adjusted performance as what appears to be a “check box” in addressing risk in the proposal. Quite often, the proposals fail to ask questions to get at the heart of qualitative risks that can lead to permanent capital loss. These proposals tend to look for risk-related statistics around standard deviation, Sharpe Ratio and beta, capturing volatility, returns relative to volatility and asset movement relative to the broader market. While important, these stats do not capture an inherent risk: that an investment may result in a loss of capital. Risk-related questions should not be “check boxes,” but rather core elements of the due diligence process.
Due-diligence questions that address qualitative risks
These questions will help give you better insight into a provider’s investment process and how it protects assets from qualitative risks that could lead to irreversible capital loss.
Avoid the worst case scenario
- Describe your operational due diligence (ODD) process: How has your ODD process has evolved over time? What are the major differences among your ODD process for liquid asset managers, private equity managers and hedge fund managers?
- Highlight examples in which you recognized you assumed undue risk that caused you to improve your process.
- Highlight examples in which you avoided a potentially risky manager or a manager that "blew up" because of your ODD process.
A poor outcome for an asset owner would be an investment in a manager that loses capital due to inadequate internal processes or, worst case, their practices are fraudulent. Every provider will claim to perform operational due diligence, but the degree of diligence will vary. There is even variance across sizable asset owners with the scale to employ internal investment teams, including some who take diligence shortcuts.
A good diligence process includes a review of manager documents and policies to gain an understanding of operations, valuation policy, lifecycle of a trade, IT infrastructure and compliance. Once the team understands the basic operating setup, it should conduct meetings with key personnel including the chief financial officer (CFO), chief compliance officer (CCO), chief operating officer (COO) and head of trading to determine the institutional quality of operations. The objective of these meetings is to ensure implementation of written policies, adequate internal controls and proper segregation of duties.
The ODD team should study changes in assets under management, the ownership structure, key hires and departures, compensation structures, strategic plans and other material issues. Ask questions such as:
- Are any of the terms in the offering memorandum outside industry standard?
- What are the details of key vendor relationships?
A thorough examination includes a background check on the manager and key employees. Also, operational due diligence should not stop after the initial diligence. It should include an annual review plus ongoing monitoring of the manager, including an investigation of any updated documents, regulatory filings and audited financial statements.
Any examples should demonstrate an environment of constant improvement and refining of process. Mistakes may happen, but these should be learning experiences.
Use conservative assumptions
- How aggressive or conservative are your capital market assumptions?
- Provide concrete evidence supporting your claim.
- Describe how you use your assumptions to make strategic or tactical portfolio decisions.
The playing field for all advisers is the same. No one has a crystal ball, but some have better processes, which can lead to principles that are more conservative and often result in more prudent decision-making.
For context, consider a blended 60% equity and 40% fixed income portfolio2 over a 30-year period from 1980 to 2010. Starting any year from 1997 to 2007, the 10-year annualized return for this index exceeded 7% just once with a 7.2% annualized return from 2002 to 2012. The other 10 starting points put up annualized returns that ranged from 2.4% (1998 to 2008) to 6.6% (2003 to 2013).
Chart 1 below graphs the annualized 10-year return for each starting point. For an 11-year period from 1997 to 2007, the aggregate portfolio over the next ten years failed to achieve a 7% annualized return hurdle 10 of 11 times. Near the tail end of the market cycle, the capital market assumptions often will have a lower probability of proving prescient.
Providers often tell prospective clients what they want to hear to win their business, rather than what those prospects need to hear for proper planning.
What would an investment committee prefer — a provider that provides optimistic assumptions with a higher probability of negative surprise, or a provider that makes conservative market assumptions with a higher probability of positive surprise?
In the former, the negative surprise results in a scramble for capital. In the latter, the committee can prepare for likely lower portfolio returns and secure capital in advance to meet a potential shortfall. With positive surprise, the investor enjoys not just a surplus, but stronger financial footing for future planning.
Chart 2 below highlights a range of market projections. The assumptions from “optimistic” advisors suggests a 50% chance of meeting an annualized 7% return over the next ten years. Projections from “conservative” advisors suggest a less than 30% chance of a 6.5% annualized return over the next ten years. These projections can be critical to planning.
Annualized Expected Returns
Conservative assumptions create an environment of honesty, which drives a careful asset allocation strategy. With more optimistic assumptions, it might be tempting to increase risk in order to benefit from more forecast that are more aggressive. A riskier portfolio means a wider range of outcomes, including some outcomes with materially lower returns (perhaps even negative) over a 10-year period. Higher risk typically includes a higher allocation to both public equity and private equity strategies.
Ensure robust liquidity to withstand the harshest environment
- In 2008-2009, the market suffered a severe global downturn. Describe how your actual exposure to private market investments changed for your (conservative, moderate, aggressive) portfolio on a monthly basis as liquid markets sold off. Specifically, explain how you sourced cash to meet any capital call commitments.
- What policies and procedures have you instituted since the Great Financial Crisis to better manage your liquidity requirements and prepare your portfolio for private equity capital calls during the next crisis?
Veteran investors vividly recall the wild market moves of 2008-2009. For some, it was baptism by fire on how all parts of the financial markets intertwine. For many asset owners, the team sets an allocation to private equity. Due to the nature of the investment, capital is committed as opposed to an outright cash outlay and forecasting liquidity is critical. Sitting on too much cash to fund commitments creates a cash drag. Not holding sufficient cash can potentially cause permanent capital loss at inopportune times.
Investment teams regularly include distributions from private equity managers as part of their liquidity planning to fund future capital calls. In times of financial distress, like 2008, private equity managers try not to sell portfolio companies meaning they do not make distributions to investors. In many instances during these turbulent markets, private equity managers will look for opportunities that can result in deploying more capital. Rather than selling portfolio companies and receiving cash for distributions to investors, managers call capital from investors to collect cash to fund new portfolio company investments.
For investors relying on distributions to fund some of their upcoming commitments, this creates a cash crunch. In 2008, many investors had to decide which assets to liquidate in order to come up with cash to fund private equity calls. Do they sell equities when the S&P 500 is down the 37% it was in 2008, or bonds that provide ballast to the portfolio in a highly uncertain time? A forced sale in the heart of a sell-off means crystalizing a permanent loss. Prudent asset allocation decisions and liquidity forecasting are critical. Times of crisis can provide great insight into how carefully a manager thinks about asset allocation and liquidity forecasting ensuring prudently managed investment strategies, even during times of financial stress.
One cannot manage what one cannot measure
- What are the key aggregate portfolio metrics you measure, so that you always know how you have allocated capital?
- Can you generate portfolio exposure reporting across all asset classes?
- What systems and processes do you use to track aggregate portfolio exposure by asset class, sector, country, carbon and risk factors like oil or interest rates?
Portfolio exposures such as asset class, sector and country exposures are unique in their surface level simplicity, but are actually complex and require a provider to have the proper infrastructure to provide efficiency and accuracy.
For example, it is easy to get the sector for each of the stocks that comprise a long equity manager’s portfolio and roll that up to calculate that one portfolio’s exposure to Information Technology (IT) or healthcare. It is hard to get the sector for each bond issuer for fixed income managers, plus the same exposures for each hedge fund manager and each private equity manager’s portfolio companies, and the sector for any direct private investments. It’s even harder to get all that data into a single data warehouse, structure the data consistently from one manager to the next and then roll all that data up to know what the overall portfolio’s exposure is by sector.
Knowing this information is essential for strategic portfolio decision making. Investment managers tend to flock to the hottest sectors, while passive index investments naturally allocate more dollars to the largest companies. During the tech boom and subsequent bust, IT sector exposure grew to over 30% of the S&P 500 as managers loved the growth stories and failed to appreciate the value of businesses across manufacturing, supply chain and distribution. Just prior to the financial crisis in 2008, financials expanded to over 20% of the S&P 500 versus historical levels of 10-12%. Investors must be able to roll up sector exposure by manager at the portfolio level to know where the overall portfolio has concentrated exposure and ensure that is not an area of manic market excitement or a growing bubble.
In the current environment, many investors are concerned about potentially outsized inflation and the rise of long-dormant bond vigilantes selling bonds and forcing rates higher. Providers should be able to tell their clients how an interest rate shock will affect their portfolio, but proper systems to do this require an impressive data architecture and powerful applications to crunch the numbers. These systems are not cheap, but the downside of not using them is an improperly structured portfolio on the wrong side of a risk factor that could cause an irreversible capital loss.
Putting it all together
In January 2021, Reddit, WallStreetBets and the up and down stock price of GameStop made headlines. The “short squeeze” that occurred forced some investment managers to close out a short position at the worst possible time, resulting in a loss of significant capital. Those investment managers – and their investors - learned the hard way that a large permanent loss of capital is difficult to overcome. Despite a seemingly large return in February, it was still not enough to overcome the decline in January.
The severity of permanent losses is a major risk for institutional investors who should consider anything that can mitigate that risk. Ask investors who historically fell victim to fraudulent investment managers and their wish in hindsight to take the visible red flags more seriously. Riding out the volatility does not offset a permanent capital loss. An ongoing, serious effort around operational due diligence could help prevent it.
1CFA Institute. May 2010. Elements of an Investment Policy Statement for Institutional Investors (Policy paper).
2Portfolio has an asset allocation of 30% S&P 500, 15% Russell 2000, 15% MSCI EAFE, 15% Barclays Government, 15% Barclays Investment Grade and 10% Barclays Aggregate
Information provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company.
Investing involves risk including possible loss of principal. There can be no assurance goals will be met nor that risk can be managed successfully.
This material represents an assessment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.