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With risk tolerance being tested for the first time in a decade, investors are reconsidering their risk appetites. Advisors have a plentiful choice of tools to assess investor risk tolerance. But the same isn’t true on the institutional side.
The COVID-19 crisis has, among other things, roiled the major stock and bond markets around the world. We’ve had several days in a row of wild gyrations, exceeding +/- 5% for major U.S. and global equity indexes. In fact, nine of the 10 trading days in the first half of March had close-to-close moves of 3.7 standard deviations or more. On three days, the moves exceeded 10 standard deviations. On the bond side, we’ve seen a rally in long term Treasury rates to unprecedented levels and then a plunge. Since then, there’s been a recovery – all in the course of a month. At the same time, we’ve seen spreads for lower grade bonds rise suddenly.
Amid all these moves, we also encountered seismic shifts in the oil market. An oil price war has broken out between Saudi Arabia and Russia, apparently in retribution for Russia’s unwillingness to reduce production in line with OPEC. Both producers seem intent on forcing the other to blink first and, in the meantime, oil prices have spiraled downward to well below production costs for most of the producing nations. The COVID-related fluctuations when the oil market encountered a political contest compounded the market turmoil and the stress visited on investors.
On the retail side, risk tolerance/appetite measurement tools typically seek to explore several variables that are thought to relate to personal differences in tolerance and capacity to sustain risks. Not all tools cover all of these categories, of course:
- Age and investment time horizon
- Experience with investments
- Personal investment objectives and degree to which they are specifically defined
- Relationship between assets and obligations
- Relationship between assets and annual cash flows
- Tax considerations
- Personality-related ability and willingness to tolerate investment stress
- Anxiety associated with investment losses
Broadly, we might think of the sections of a typical questionnaire as attempting to address the individual’s technical and logistic capacity to withstand negative market events and their demographic- and personality-driven willingness to do so.
Similar assessments might also be useful for institutions, including defined-benefit pension plans, OPEB plans, not-for-profit organizations, and institutional trusts. It is important for them to reassess their capacity to withstand adverse markets as well as their institutional tolerance for risk. With that in mind, I searched to find tools that could help advisors have a risk-appetite conversation with the committees responsible for those assets.
To my surprise, I was unable to find a single example of a risk questionnaire or guide tailored to the structure and objectives of institutional investors.
While there are some parallels between individual and institutional perspectives on risk, there are also several important differences. Some of these include:
- Agency in decision making – Individuals often make decisions on their own behalf while institutional committees are usually fiduciaries and proxies for the organization as a whole or for third-party beneficiaries.
- Asymmetric risk-reward functions – Individuals are usually equally exposed to upside and downside market outcomes (even if the pain costs are asymmetric). However, institutions may have different reward/penalty functions and may not get 100% of an upside move (e.g., in the case of a pension fund that has divert funds in excess of 105% of projected levels) or might be penalized economically (e.g. risk surtaxes) for asset deterioration beyond a specific level.
- Integration with institutional objectives – Individual objectives are usually fairly simple as they might pertain to major purchases (house, boat, college education), life decisions (retirement), more or less clear time horizons. Institutional decisions might have these same qualities (funding for a specific capital project) or may be broader and more variable (funding pension commitments for a generation).
- Dependencies – Individuals might experience a dependency between their capacity to withstand losses and job status and income. In an institutional context, this might translate into a correlation between market levels and donor generosity, or might be dependent on tax laws or discount rates.
In trying to put together an institutional risk questionnaire, I also wanted to distinguish risk from an investment policy statement (IPS). The former is narrow in what it tries to uncover. On the other hand, the IPS has a larger role that includes articulation of risk preferences, but also outlines asset allocation parameters, defines elements of implementation such as manager assessments and acceptable and prohibited instruments, and roles and responsibilities of the various parties involved in the management of the assets. Both are important as vehicles for internal communications and to build consensus within the organization regarding the management of the assets.
With these considerations in mind, I drafted the institutional risk questionnaire below. Because institutions are likely to use committees to manage their assets, rather than vest responsibility in a single person, this is designed to elicit discussion and build a consensus.
I welcome feedback and suggestions as I work to produce a final version.
How to use this questionnaire: This questionnaire can be used to start a broad and free-form conversation about the financial condition and risk appetite of the organization. It is also possible to use it in a more specific sense by attaching numerical scores to each part or question and generating an overall “risk score” to express how conservative or aggressive the organization can afford to be with its investments.
Organizational structure
To whom is the committee responsible (membership? senior management? board of directors? national organization? the press?)?
To what degree are individuals not on the committee held responsible for the investment results? What is their input into the investment or allocation decision process?
What are the important organizational sensitivities? These might relate to potential conflicts with donors, reputational risk issues, home office/subsidiary organizational issues.
What are the purposes of the assets?
Are assets segregated by purpose/time horizon or are they in a single undifferentiated account or holding vehicle?
Are returns, income or realizations from asset investments taxable? Are losses deductible versus income statement or balance sheet?
Organizational financial constraints
How do organizational objectives relate to this pool of assets?
How would you describe the general financial condition/health of the organization and its ability to execute its mandate day-to-day? Is the current condition dependent on using or drawing from these assets on a regular basis?
Is the operational financial state stable, improving, or deteriorating over time?
Do the assets have a defined role in providing regular support to the organization? (e.g., is there a specific annual draw expected from the assets or do they offset a specific liability such as a pension plan or building project?)
How does the asset position (balance sheet) of the organization compare in size to the operating needs and cash flows (income statement)? How would moderate fluctuations in the organizational income impact its ability to provide for its operational needs?
Does the organization anticipate significant changes in the next couple of years? Increasing spending? Contracting mission? Increase/decrease in external funding? A redefined mission/mandate? Significant merger or acquisition? Change or expansion of mission?
Are any of the assets constrained in their uses or investment options by, for example, donor directions, or legal mandates?
Are there any upside/downside constraints on the credit that the fund or organization receive associated with returns? For instance, if a downside returns floor is breached, is the organization penalized? If assets or returns exceed an upside ceiling, are excess returns redirected?
Scenario considerations
How would the organization’s financial condition, including costs, income, donations, third-party revenues be impacted if:
- A 12-18 month moderate recession were to hit the U.S.
- Event-related sudden drop in the stock market occurred
- Inflation rates were to increase materially
- The stock market declined significantly for two or three years
- Interest rates on fixed income instruments would decline materially
- There was a significant change to government leadership at the state or federal level
- Personal and corporate tax rates increased or decreased
- Local or country-wide unemployment increased significantly
Investment considerations
Is there a defined sunset date for the assets, either in terms of institutional objectives (a building fund) or legal (a trust with a termination date)?
Is there a required annual cash distribution from the assets?
Are there legal constraints on the amount of portfolio risk or types of securities that may be held in the portfolio (e.g., an insurance fund)?
If the value of the assets were to fall by 5%, 10%, or 20% for a couple of years, would that create any financial problems for the organization?
To what extent might one suppose that declines in the stock market or increases in inflation, or interest rates are correlated with cash flows of the organization through billings, government receipts, donations or other channels?
How important is asset liquidity (ability to sell assets quickly without having to accept significantly below-market prices) to the organization?
Transparency of investments: How important is it that the type, contents and characteristics of investment assets be clear?
Are there tax considerations associated either with investment types or with buying and selling transactions?
How do the combination of time horizon, purposes of the assets, operating income requirements, funding constraints translate into investment objectives for the assets?
Eric Stubbs has worked in financial services in New York for 30 years, most recently as a financial advisor managing a global investment strategy. He earned a Ph.D. in economics from Harvard.
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