FCLTGlobal, with its Members, is developing practical tools to address the issue of balancing long- and short-term risks. Part of the process includes interviews with experts in the area of assessing, managing, and planning for investment risk. Below is the next in this series with Will Kinlaw and David Turkington, Senior Managing Director and Senior Vice President at State Street Associates, respectively. As State Street’s academic affiliate, State Street Associates is a unique partnership that bridges the worlds of financial theory and practice. SSA develops risk, investor behavior and economic indicators as well as investable indices for investment managers and institutional investors around the world.
FCLTGlobal: Thank you, Will and Dave, for participating in this conversation about the ways that long-term investors measure risk. The issue of risk measurement has been one of the harder ones for us to address because there is some difference of opinion about the extent to which it matters specifically for long-term investors. How much does it matter for them, if at all?
Kinlaw: Risk measurement is important for all investors and especially long-term investors. Suppose you are 10 years into a 30-year investment horizon and you’re down 20%. Does this mean that your assumptions were wrong and your investment strategy is broken? Or are you just experiencing an interim drawdown that is consistent with the strategy’s inherent risk? Should you hit the reset button or stay the course? This example illustrates why it is so important for investors—and their stakeholders—to understand the difference between within-horizon and end-of-horizon risk.
Some institutional investors, like those with very low current cash flow needs, may be tempted to concentrate only on risk at the endpoint of their horizon. They might implement their strategy for a three- to five-year period and then, at the end of the period, step back and re-evaluate the fundamentals and their capital market assumptions. The question is: how should they measure risk over this period? Value-at-risk, as it is defined in the textbooks, is an end-of-horizon measure. If I tell you with 95 percent confidence that the five-year value-at-risk for your fund is $550 million, it means that there is a five percent chance that you will have lost more than $550 million at the five-year mark.
"The probability of being down by, say, $550 million (or any other threshold amount) is much greater during the investment period than at the single moment that it ends. That is a mathematical fact. Of all the possible paths that your portfolio could take over five years, many of them will dip below that loss threshold and then recover. Investors who are concerned with the path—that is, what might happen along the way—need to use a continuous measure of risk.” -Will Kinlaw
But this doesn’t tell us what might happen along the way. Most investors – and most investment trustees – perceive risk in a more continuous way. Boards often meet quarterly, and they look at performance. And the probability of being down by, say, $550 million (or any other threshold amount) is much greater during the investment period than at the single moment that it ends. That is a mathematical fact. Of all the possible paths that your portfolio could take over five years, many of them will dip below that loss threshold and then recover.
Investors who are concerned with the path—that is, what might happen along the way—need to use a continuous measure of risk. Two such measures—within-horizon probability of loss and continuous value at risk—were introduced by Mark Kritzman and Don Rich back in the early 2000s in an award-winning paper in the Financial Analysts Journal.
Returning to our previous example, if your portfolio’s continuous value at risk is $700 million (with the same confidence level and time horizon), that means that there is only a five percent change that you will be down more than $700 million at any point during the investment horizon.
Measures like this help to set trustees’ and managers’ expectations for the types of interim losses they might incur. It’s critical to set expectations carefully. Otherwise people can make irrational decisions and change course at the worst possible time.
FCLTGlobal: This sounds like an incredibly important point for an investor trying to remain committed to a long-term strategy.
Kinlaw: Yes. People are prone to panic selling and other irrational decisions when they lack a good understanding of their within-horizon risk. Most of us have a relative who sold all the stocks in their 401k at the depths of the financial crisis — and are now regretting it. If they had understood that the likelihood of these within-horizon losses, perhaps they would have been able to stay the course. I think those sorts of examples can help.
Turkington: The inverse issue is equally important. Many people believe that risk diminishes over time. From this view, if you have an investment with a positive growth rate and you reinvest in it over many periods, the fluctuations cancel out and you are left with a reliable gain. Some call this “time diversification.” This notion is misleading because the size of potential losses increases with time, even though the chance of loss goes down. Losses can compound just like gains.
“The size of potential losses increases with time, even though the chance of loss goes down. Losses can compound just like gains.” - David Turkington
FCLTGlobal: We often hear that the long term is just a series of short terms that add or scale in a predictable way. Is long-term risk different than the sum of its parts?
Turkington: The common approach to measuring long-term risk is to make simplifying assumptions that the long run is a sequence of short run events and each of those short run events is independent from the other.
Those assumptions are very bad approximations to reality. Prices trend, rather than being independent over time. For example, it is well-known that the stock market tends to trend with a momentum effect in the short run and tends to revert to the mean in the long run. Likewise, the bond market tends to trend because interest rates are persistent and long-lived.
When an investment tends to trend in a positive way, then it’s long-term risk is going to be greater than you would otherwise assume. And long-term risk could be less than you would assume if the assets mean-revert and self-correct over time.
FCLTGlobal: I know you have written on this topic and on the importance of not relying on short term time periods when sampling data. Computing risk statistics using short-term data samples can result in dramatic underestimations of risk, correct?
Kinlaw: Yes. The impact of the issue that Dave just mentioned is non-trivial. We modeled this over three years for a traditional pension or sovereign wealth fund allocation that starts with the benchmark position and adds some strategic tilts. In the example we looked at, an investor would underestimate the chance of underperforming the benchmark by 50 percent if they used the standard approach. It is critical to adjust for these factors. But nobody does it. Every risk platform that we know is written in the standard way. In fact, the CFA Institute’s global investment performance standards (GIPS) require investment managers to annualize risk (standard deviation) in the Sharpe ratio denominator from monthly observations in order to be compliant.
FCLTGlobal: Why hasn’t the magnitude of this effect led investors to change their behavior already?
Kinlaw: It takes time. For example, the notion of risk factors was introduced by academics in the early 1990s (some might argue even earlier) and yet the industry is still trying to figure out how to incorporate them almost 30 years later. Still, we do see clients thinking very much about these issues in the current environment.
FCLTGlobal: I would like to ask you both about how trustees or investment boards relate to this material. What have you observed about the ways that trustees use these risk measures? Does the way that they use them affect their ability to focus on the long-term?
Kinlaw: With boards, one of the biggest challenges that investors face is the wide variation in investment experience. A simple exhibit helps to communicate many of these things. You can show a portfolio and the path that it might take over time. People can relate to that – they think about what action they might take in a particular scenario.
“The crux of risk management for a large institution now happens in the formation of the strategy and the foundational decisions around portfolio structure.” - Will Kinlaw
I think the question of how trustees use this information is very important for the long term. Many people assume that most of risk management is about monitoring and reporting VaR and other statistics. In fact, the crux of risk management for a large institution now happens in the formation of the strategy and the decisions around the asset allocation. That is where 90% of risk management happens. Monitoring and reporting just follow from that.
FCLTGlobal: Thank you both for sharing your insights with us today. Your points are very well taken, and we expect to encompass them explicitly in a forthcoming publication on risk for long-term investors.
The views expressed in this article are solely those of the authors and do not reflect the views of State Street Corporation. All numerical examples are illustrative. Past performance is no guarantee of future results.