Recent volatility around the world, both politically and economically, shows how important it is to know your portfolio’s risk profile.
Market volatility and stress have increased the importance of measuring risk. The NeuGroup’s Treasury Investment Managers’ Peer Group at its most recent meeting examined the metrics members used to measure risk, how they manage risk reporting and how risk metrics are incorporated into the investment decision.
Here are a few of the main takeaways:
Members have many ways to define risk and most include duration in the risk analysis. Also, metrics involving capital or earnings are popular. These metrics were mainly credit capital or earnings at risk, although they also use historical volatility to measure risk.
It’s hard to emulate the way any one company goes about reporting risk. That’s because there are as many management reports as members in the group. Each company and investment board has particular reports they want to view; the reporting cycle is just as varied, ranging from weekly to quarterly.
Giving structure to a complex investment portfolio. One member presented to the group, his company’s portfolio risk, and compliance and reporting frameworks. His group’s role is to manage excess capital that comes up to the parent company level, and a dual treasury mandate to be a consultant to business groups. This company has decentralized treasury personnel and these groups have their own working capital to invest; the presenting member’s group is a resource to help them manage these assets.
To manage their risk, the company has tiered the investment portfolio to allow for immediate operating needs in a liquidity tier and take on more risk with assets they do not require for immediate business functioning. The tiers are aligned as thus:
- Tier 1: Includes T-bills, bank deposits, and commercial paper. It is their goal to push as much as they can to riskier assets beyond what is required for operating purposes or stress events. This segment requires less reporting and risk measurement as it contains less risky assets.
- Tier 2: Enhanced cash. The target duration for this segment is 12-18 months. These portfolios are managed in-house and externally. In this segment more risk management at parent level is performed. A risk budget is determined by the amount of market and credit risk that the company can take. An MCAR (market capital at risk) calculation is provided to management. This number represents the dollar amount of loss in a liquidation scenario based on historical price volatility. Credit risk is evaluated by the dollars of simulated losses from the rating agency default tables. Not only is less liquidity required for this segment but also the investments have more of a long-term focus.
- Tier 3 – Hedge fund portfolio. The target volatility is 6 percent and return is Libor plus 5-6 percent. The management of this tier is partially outsourced to the pension group and others in the Treasury group fully dedicated to hedge fund relationships.
When members think of risk, they think of metrics and reporting. An additional way to manage risk is to separate the portfolio into buckets. Each bucket is aligned with an operating or capital need. Each tier or bucket can have a unique investment policy and set of risk metrics. Measuring risk is also easier and more efficient; this methodology also allows you to spend more time in the areas that contain more risk. Another benefit is that when you outsource the management, a specific investment policy can be given to the external managers for that particular segment. When considering risk, think systems and segments.