HOME Recent Events RMI in the News ALUMNI
  Issue 1 | Archive   16 November 2009

Risk Management Challenges for Long-term Investment Funds

By SUNG Cheng Chih, Chief Risk Officer, Government of Singapore Investment Corporation

Long term investment funds (LTIFs) are collective schemes which have a formal governance structure. They are managed by professionals and have a separate oversight body. They hold a diversified portfolio across multiple countries and asset classes and their investment policy is driven by liabilities. There are various types of Long term investment funds such as endowments, foundations, pension funds, sovereign funds.

LTIFs are faced by a wide spectrum of risk which can be classified into compensated risk and uncompensated risk. Compensated risk would include market risk and liquidity risk. Uncompensated risk would include counter party risk, legal risk, and reputation and so on. Investment risk is driven mainly by asset allocation policy since there is diversification across asset classes and geography.

Risk management plays a very vital role since neither the banks nor asset managers offer good risk management models for long-term funds. For these funds, risk management must by necessity encompass both risk control and risk efficiency. Relative emphasis on control versus efficiency is dictated by whether risk is compensated. Risk management is thus a constant balancing act between control and efficiency.

Asset allocation serves as the main driver of portfolio risk and return for the fund. More than 90% of portfolio risk is driven by asset allocation strategy. Even though equity risk dominates, the alternatives to equity-centric portfolio have been largely elusive as the 'risk-parity' portfolio comes at the cost of huge leverage risk, tail risk insurance are generally not scalable, and to maintain a portfolio of dynamic strategies is quite a task and a huge risk since it relies solely on skills and requires constant juggling.

Private market and hedge fund investments pose a lot of technical problems for the fund. Such as opaque vehicles with embedded leverage, assets are re-valued infrequently and with considerable delay, valuation methodology is distorted by accounting practices with inherent smoothing and lack of risk models that cover both public and private assets.

Macro portfolio strategies for LTIFs should aim to develop fundamental factor models for asset allocation and macro risk management which covers medium to long time horizons and encompass both public and private markets. Also there should be dynamic allocation strategies that bridge long-term policy and short-term TAA.

There should be an early warning system for market dislocation to enable monitoring of deal terms, risk premia and surveillance of leverage and market positions. Crisis transmission mechanism should ensure availability of liquid hedging instruments and de-leveraging and redemption paths.

Scenario analysis would help add clarity to connection between assets and liabilities. Well-crafted scenarios enrich policy formulation both quantitatively and qualitatively. Volatility- and VaR-based measures work better as short-term, "peace-time" tools. Examples of long-range risk scenarios include global pandemic and food shortages, natural disasters and climate change, geopolitical conflicts and CNB terror attacks.

For the better performance of these funds there needs to be a better understanding of overall return and risk drivers. Risk associated with illiquidity and forward commitments should not be ignored and liabilities need to be taken seriously.

Back To Newsletter

Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)