PRESENTER: Fund managers spend a lot of time looking at risk and reward, but who spends their time keeping an eye on the fund managers. And how important is it in ensuring that investors get the outcomes that they’re expecting from multi asset portfolios? Well in this Akademia session I’m joined by Pablo Balan - he’s the Investment Risk Director at M&G Prudential - to talk through the issues. And here are the learning outcomes. First, understanding the different types of risk within a multi asset portfolio; second, how you can monitor and manage risk in a multi-asset portfolio; and thirdly the importance of having a clear and independent risk framework. Well when Pablo Balan came into the studio I began by asking to define what he means by risk and then to drill down into the main components.
Pablo, we’re talking about managing risk in portfolios, but can you define what the different types of risk are that we’re talking about?
PABLO BALAN: So we think about risk from multiple angles, multiple perspectives, and investment risk is a subset of these. There’s a narrow definition and a broader definition. The narrow definition is that investment risk is about the impact that market movements can have on your portfolio, combined with a performance element, which is are you actually meeting your objectives or not relative to what you set out to do. From a broader perspective, there’s other types of risks that would qualify as investment risk, because they impact investments in general. So I’m thinking here of things like credit risk, your counterparties, the fixed income positions that you might have that could potentially default, that would have an impact on performance, even though technically it’s a separate category within credit risk. Liquidity risk, how easy it is or not to access the money that you’ve invested without having a significant market impact. That’s obviously relevant when you’re transacting. And you need to keep an eye on that, depending on your time horizon that might be more or less important. And then finally operational risk is really the risk that you have, failures in your investment processes or in your people and things everywhere from systems malfunction to fraud or fat-finger errors, things like that, would qualify as operational risk.
PRESENTER: So how correlated are these five buckets to each other, because it looks like they could all overlap to some degree?
PABLO BALAN: There are some overlaps. So as I mentioned if you have, credit risks affects not just whether a bond defaults or not; you could have increased credibility or decrease in credibility of an issuer, and that will affect the market pricing, so that links to market risks. And obviously liquidity has an impact on pricing as well, and that can impact performance, so there’s lots of linkages.
PRESENTER: And presumably the operational risk can have an impact on performance as well.
PABLO BALAN: Yes of course. You can have large losses on the back of people not doing the things they’re supposed to do, or having operational errors.
PRESENTER: Taking that idea on then, it’s integrated, it’s not just what the markets do, it’s also what the portfolios do and the way that the people run the portfolios, so all of this together. How do you monitor and manage investment risk in a multi-asset portfolio?
PABLO BALAN: So there’s many different people involved in managing these portfolios. Typically, we follow a distinction between first line and second line. Meaning the first line are the teams and the people that are actually responsible for managing risk, managing the fund, so this would be research, portfolio managers, asset allocators, manager selectors and people who do due diligence on managers, and then a second line is risk, compliance, legal, so support functions that are meant to oversee and ensure that people doing their jobs are doing it in a thorough enough fashion. So risk technically sits within that second line, although we have very strong interactions with all of the investment teams and we work quite closely with them. And the key there is that risk isn’t purely a second line function; there’s risk management within the first line functions, within portfolio management teams. Their primary responsibility is to manage their portfolio in a way that’s consistent with our risk framework. So there’s two sides to that.
PRESENTER: You talk about first and second line there, and how important is it to keep those two functions, those two teams separate, independent from each other?
PABLO BALAN: It’s crucial. Especially when you’ve got an organisation that’s as large and complex as ours, there’s always room for conflicts of interest, so people having to think about their line management, but at the same time clients and regulators, and risk as a function reports separately from the first line, and that’s key in ensuring our independence. We’re not compensated on the back of investment performance, on how well the funds are performing, because that would skew us towards potentially taking more risk, or allowing things to happen that would otherwise not be in the interest of clients and policyholders.
PRESENTER: Now, you’re sat in the middle of a huge organisation, but as an adviser sat on the outside you’d always say to them whoever you’re using as a provider, make sure those two functions are separate. You can work out what clear mandate each has and how they interact.
PABLO BALAN: Absolutely, I think it’s important when you’re looking to invest in any financial product that you understand what the different teams are that manage those assets and that you’ve got that sort of second line check. In some places it’s more formal than others. Sometimes it sits within the first line function; sometimes it’s a separate function. There’s something called the three lines of defence model, where the third line is audit, and they come and do reviews. The larger the organisation, typically the better staffed these secondary functions are. There’s a balance, because obviously if you’ve got too many people in risk, compliance, audit, then the business gets lopsided and it’s difficult to get things done, and you need, especially in asset management you need teams that can actively pursue opportunities that are reactive to market conditions. You don’t want them to have to go through hoops and hoops of bureaucracy to be able to do the things that they’re supposed to do.
PRESENTER: Well, you’ve talked about that architecture of risk around the portfolios. So let’s bring our second slide up. Talk us through what’s going on here.
PABLO BALAN: This slide addresses the investment process. So there’s several different stages that we go through to manage portfolios. And I’ve outlined four broad ones here. And the key point here is that risk are involved in every step of the process and that we’re actively engaging with the people making the decisions on each of these. The first thing that our investment professionals do when they start putting together a multi-asset fund is to think about what are the various different asset classes that they want to come into the portfolio. And that means extensive modelling and research into each of those asset classes. And the funds that we manage, some of them have 20-25 different line items in terms of asset classes, so it’s fairly complex and intricate work. And so we have committees that go through the assumptions that go into modelling each of these asset classes.
So for example with equities, what kind of returns can you expect from equity markets going forward over the next 10 years? That’s a very difficult question to answer and it depends on multiple factors. And it varies depending on which geography you’re talking about: are you talking about emerging markets, are you talking about developed markets, are you talking about small cap stocks, large cap stocks, private, public equity? So it can get quite intricate. And from a risk perspective what we want to make sure is that there’s a robust process that looks at things in a consistent way. That you don’t have people saying oh I like German equities for whatever reason, I’ve got an angle on this. That stage of the process is not really about people’s individual views; it’s more about a systematic approach to modelling asset classes. And we get quite involved in that process, reviewing what people do there.
PRESENTER: Just picking up on that, you could have a process that takes, says well let’s look at the facts, rather than let’s have a motion and get the facts to back it. But how robust is the process? I mean do you claim it has some sort of predictive power of what returns are going to be?
PABLO BALAN: So returns as I said are very difficult to predict. And what this team is doing. There’s a team called long-term investment strategy team that do this research. And there’s I think another session with one of my colleagues on that. And they’re basically looking at long-term what are called equilibrium returns. So over, not trying to predict the market cycle, are we at the end of a cycle, at the beginning of a cycle, when are we going to get a recession, that’s something that’s interesting but very difficult to do. It’s more about structurally from a long-term perspective they take what’s called a building blocks approach. So you’ve got what do we expect cash to do? On top of that, what do we expect fixed income assets, term premium to return over the next 10 years? And on top of the things like equity risk premium, all these things depend on the starting values of assets. So if equities are very expensive today, then you can expect longer-term expected returns to be lower than if they’re cheap. And on a long-term basis that’s proven to be quite a good indicator of long-term expected returns.
Our role there is not so much with the modelling; it’s understanding what are the risk drivers? So when you look at equities, what are the assumptions around volatility, correlations, how do we expect these asset classes to move in a portfolio context? Are they diversifying from each other or have they got similar risk drivers; can we expect them to lose money at the same time and therefore we have to be careful about how much we allocate to those assets in a portfolio.
PRESENTER: So that’s the asset classes, just driving down then, strategic asset allocation.
PABLO BALAN: So those asset class assumptions feed into the decisions as to how much to allocate to each of those, and so there’s quantitative inputs and qualitative inputs. Our role there is really to review again the methodology, to review every time that process goes through, which is once or twice a year, to make sure that any changes that are being proposed have sufficient merit and that those recommendations aren’t taking us away from our risk appetite. So there’s a pre-set risk appetite for the funds based on the objectives and the capital constraints, and we don’t want to go over those, or indeed to be significantly below, because we’re targeting a particular rate of return over a long period of time.
PRESENTER: And again when you look back on the decisions you made, what’s the difference between we got it wrong and we got it wrong for the very best, for much better reasons than people who haven’t done all the work we’ve done?
PABLO BALAN: So I think, look, everyone, no matter how good and robust your process is you’re sometimes going to get it right and you’re sometimes going to get it wrong. And I think the key is just making sure that you maximise the chance that you’ll get it right on most occasions. And it’s not so important to get every single call right when you’re managing a well-diversified portfolio, which is what we typically do. What’s important is to have that process in place so that you’re consistent in your approach year-on-year, because things do tend to mean revert. So if you got it wrong in one year, then as long as you stick to the same process you might mostly likely get compensated for that the next year. Or if you’ve got one asset class wrong, you might in most instances be compensated by some other asset class in your portfolio.
PRESENTER: And how important is it to get the mandate right? Because I think over the years anybody in financial services has seen products that look great, but in retrospect they promise to deliver things they couldn’t deliver, they’re a bit unrealistic.
PABLO BALAN: So that’s a key point. My team doesn’t get quite as involved in the product development. And, you know, what goes on the tin when the products are sold to clients, there’s risk people involved in that process as well. But as you say it’s very important, we can talk about it a bit later when we talk about the different stakeholders in the process, but it’s very important that we communicate clearly what we expect products to deliver and that we stick to those objectives over time. The worst thing you can do is to change your strategy halfway through, when you’ve communicated you’re doing one thing, maybe returns aren’t quite what you expect, and you start taking more risk, or you have to start doing things differently just because you feel you’re behind. And that’s clearly one of the things that we monitor internally.
PRESENTER: So once you’ve got your mandate established, how do you make sure that you stay true to it?
PABLO BALAN: So there’s two mandates that we’re talking about here. So one mandate is at the overall portfolio, multi-asset portfolio level, and we talked a bit about the work that goes into it from a product design perspective. But then obviously we don’t manage all of the assets ourselves. We set out an asset allocation and then we farm out various different parts of the assets to teams within the firm and outside the firm that will manage it as best we think they can. So for example if we take a UK equity allocation, we wouldn’t be doing within the treasury and investment office the specific security selection; we would pick managers, whether within M&G or outside, that manage those assets for us. And so the third step in this process is basically to ensure that the mandate is set up in as clear and efficient way as possible.
So what’s the benchmark going to be, what are we going to ask those managers to manage the assets against; how are we going to assess their performance; what are the objectives? Are there any constraints, can they go all into industrials or technology, or are we going to enforce a certain amount of diversification, which is usually what we try to do, and so all these things go into the mandate design and then the manager selection, which is picking the best manager for the job in each asset class.
PRESENTER: And then finally tactical asset allocation, what risks should it be used to dampen down, what reward should it be looking to enhance?
PABLO BALAN: So markets obviously move around a fair bit. Some of it is due to fundamentals changing. So if the economy is slowing down or profitability is going down, then that would have an impact on market. A lot of it tends to be around perceptions and how people interpret news events. And a lot of times they’ll overreact to those events and you get this sort of herd or group mentality and suddenly something that was very much loved becomes very much hated, without having real fundamental reasons for that changing so dramatically. So there are opportunities there to take advantage of those in markets. And we have teams of people that do that again within the first line. Our role there from a risk perspective is to outline the tramlines: how far are they allowed to deviate from the central allocation? You don’t want them being able to take the whole portfolio into one asset class at any point in time; you want to make sure that there’s some pre-established guidelines as to what they can and can’t do, and we monitor that process, and make sure that.
PRESENTER: How’s tactical asset allocation any different from trading?
PABLO BALAN: Obviously to be able to implement tactical asset allocation we need to be able to trade. So in essence one depends on the other. The distinction would be that we’re not trading just for the sake of trading; we’re trying to take advantage of short-term opportunities in the market. And the key there is, and where we come in is in establishing what’s called a risk budget. So how much are you going to be placing against particular opportunities, how much money are you going to be allocating to each of these opportunities in a portfolio context? Keeping in mind that you’ve got a long-term strategy that you’re trying to meet and that’s designed to achieve your long-term objectives.
PRESENTER: Now a lot of this I guess can only take place because of the huge rise in computing power over the last few decades. How does technology and quant modelling, how’s that developed, how does that help you in risk management?
PABLO BALAN: So I think it’s easy to get carried away with the technological element of it. And there’s two aspects to it. One is the modelling side, so using computers and algorithms to model markets, to extract information from prices. And it’s very, there’s a very strong quantitative traditional approach to risk management which uses very sophisticated models that basically do that. And we use those. We have a system called Aladdin designed by BlackRock, which is one of the market leaders in that space. And it’s very good and it’s very robust, but it’s always going to be backward looking, because it’s looking at historical data. So you have to take that with a grain of salt. And you have to overlay on top of that the human element, understanding the markets from a fundamental perspective. Understanding what the portfolio managers, what the strategies are trying to do so that you also incorporate forward looking elements into that.
The other part of it, which is the automation side, we use quite heavily. So the more we can rely on computing power to take away the routine elements of reporting and day-to-day monitoring of limits and things like that, the more we can focus on the value added side, which is really getting close to the process, understanding what our people are doing, and questioning, challenging the decisions that they make at the right time.
PRESENTER: If you as an adviser said well I want to outsource, and I hear a lot about this robust very complex, very sophisticated risk model, what sort of reports, what sort of literature can you produce to help an adviser understand what you do, what the limits are, how people kept within the limits they were meant to be in? Is that easy to translate?
PABLO BALAN: So we have, obviously there’s lots of documentation on how the funds are managed, and there’s strong frameworks under which these are done, and those are communicated to clients and to advisers. We obviously do a lot of reporting internally. And I’d have to refer you to the business development people to say which bits of that external clients can access or not.
PRESENTER: But fundamentally transparency is an important part of the process.
PABLO BALAN: Obviously transparency is key, we do what we say we’re going to do, but there’s a lot of research and reporting that happens internally that’s obviously not regularly sent out to clients, because it’s meant for internal consumption.
PRESENTER: But do you ever have a point where you think well there’s lots of stuff we can measure and monitor, but are we doing it because it’s useful, or just because we can? How do you strip out the wood from the trees and concentrate on the really important things?
PABLO BALAN: This is one of the key questions in risk management. Because it’s so easy with the systems that I mentioned just to push a button and get reams and reams and reams of quantitative analysis on the portfolio. But someone has to analyse that and someone has to make sense and try to understand whether any of it is significant or not, and which bits of that need to be discussed with the first line, with portfolio managers, with strategists, and that’s our role. You know, it’s understanding both the qualitative and the quantitative elements and bringing those together that make a strong risk team. You don’t want to hand everything over to risk systems and be driven exclusively by quantitative output.
PRESENTER: So how much of this is actually face-to-face meeting people, getting a feel for them, as much as the numbers they produce?
PABLO BALAN: All the time, so we spend most of our time talking to managers, talking to the internal teams that manage the money. The longer-term strategy team, the manage selection, manager oversight team, the portfolio managers, the alternatives managers, so there’s I would say upwards of 60%/70% of our time spent on one on one discussions with them.
PRESENTER: You’re obviously covering a huge range of managers and asset classes, do each of these asset classes have the same kind of risks you need to focus on, or does it differ according to whether you’re looking at equities, private markets, bonds?
PABLO BALAN: They’re very different, and I mentioned earlier we cover so many different asset classes that it’s quite difficult sometimes to stay on top of the idiosyncratic nature of each of these. So obviously people are familiar with equities and fixed income, but we also invest in private equity and alternative credit, so things that are less accessible to retail investors. And in addition we have property mandates, we have alternative mandates that include hedge funds, infrastructure, private equity, so each of those has its own set of risks and characteristics that have to be looked at in a different way.
PRESENTER: Well talk us through, you’ve got a table here, lots of colours on it, talk us through what each means, and perhaps give us an example of an asset class [crosstalk 0:24:12] more than others.
PABLO BALAN: This is just meant to be representative. So I won’t talk through the whole thing, but if you look at something like a traditional developed equities asset class, you’ve obviously got market risk because equities move up and down in price, and that’s something that you have with most if not all asset classes. But then if you are outsourcing the day-to-day management of those mandates of those assets to a third party, or to an internal fund manager, then you’ve got to manage that relationship, and there’s a certain element of outsourcing risk that’s involved. And that’s a simple example. If you take something that’s a bit more complex, like maybe credit, where you not only have market risk, prices move because of interest rates, they move because credit spreads narrow or widen, you also have the possibility for default. So that becomes a key element in managing credit. Some of those markets are less liquid, or have pockets of illiquidity. It’s difficult to get out of them at times so you have to manage that carefully.
Moving on to some of the alternative asset classes, like infrastructure, where again you’re tying up your money for lengthy periods of time, the investments are less liquid, you have to be in there for the long run. You’ve got a strong element of legal and regulatory risk. So you have to ensure that all of that is looked into before you make the investment. And we have teams of people that do operational due diligence and legal due diligence on these alternative asset classes. We oversee that process, but we rely heavily on the expertise of the first line teams that make the decisions as well.
PRESENTER: Now the final column is headed vintage, what does that mean?
PABLO BALAN: That’s something that’s traditionally applied to private equity. It’s basically the concept that you’re investing in something that has a lengthy tie-in. So typically when you invest in private equity, you invest for a minimum of seven years, seven to 10 years. If you invest in 2019 it might be that next year or two years down the line you have a recession, and so pretty much everything that you invested in in private equity is affected by a very weak cyclical or economic environment. And so the 2019 vintage becomes a bit of damaged goods if you will in terms of private equity performance. Now ideally what you want to do is you want to invest a little bit of what you are devoting to private equity each year so that you’ve got a spread and a diversification across time. And that’s what’s meant by vintage risk is managing that diversification across time.
PRESENTER: We’re seeing more interest in investment markets with alternative and perhaps illiquid investments. We hear about the illiquidity premium, but we also hear illiquid can be bad. Can you talk us through how you think about risk in that space, particularly around illiquidity?
PABLO BALAN: We do think there’s an illiquidity premium, and we do capture it through several of the asset classes that I mentioned before. The key about liquidity is to ensure that the liquidity of the assets and the portfolio overall matches the liquidity that’s implicit in what you’ve promised clients. So depending on the time horizon that clients are looking at when they make investment, and depending on how much you expect them potentially to need their money back, you have more or less appetite for liquidity risk. And in the best of cases when clients are investing for 10, 20, 30 years, you can take quite a bit of liquidity risk because you’re going to be capturing that premium over a long period of time. But if it’s a product or an asset that clients are investing in for a shorter period of time, or where they might need their money on a short-term basis, then you’ve got to be careful to make sure that you can sell those assets in time, or you can realise the profits, so that you can pay back clients according to the contractual arrangements that you have with them.
PRESENTER: Do you have a concept of client sentiment risk? Because everybody I’ve ever met, if things are good they’re all fabulous long-term investors and then they all head for the doors when things get bad. Everyone likes patient capital until it goes down.
PABLO BALAN: Thankfully my team doesn’t have to deal with the intricacies of understanding client risk appetite. We get involved once the products are designed and developed for a particular group of clients. But you’re absolutely right, in previous roles I’ve had to deal with this. It’s very difficult to model. People do change their views. The thing is that research shows that whilst clients may change their views at any point in time and may suddenly get fearful or the opposite, bullish, very comfortable with taking on risk, the underlying nature, the psychology of individuals doesn’t change so much over time. So if you have the right way of measuring that underlying psychology, then you’ll know whether someone is prone to making that big change, or having that big change in their perception about risk. And so someone who might say they’re quite bullish or quite optimistic at the current time may actually be someone who is potentially going to flip that quite quickly and then it should be treated more as a risk averse person than their current general state of optimism would imply.
PRESENTER: And what about some of the other types of risks that arise when managing or indeed investing in multi-asset products? I suppose a key one is how do you ensure that you as a product provider’s risks are, and rewards are aligned to those of your clients?
PABLO BALAN: So that’s a key point as I mentioned earlier. And the way we think about it is when you have a fund, when you have a product, there’s multiple stakeholders involved. You’ve got clients. You’ve also got regulators who are trying to ensure that products are managed according to a set of rules, and that the clients that are going into these products know what they’re getting into, and are deriving the benefits from that. You’ve got a business that wants to be profitable and charge fees, and also wants to be sustainable, so they’ve got to invest in the right people. So there’s multiple interests involved. And risk is one of the functions that works towards balancing those out and making sure that everyone’s expectations are broadly met. And others would be compliance, compliance also looks at these things.
There’s areas where there’s key conflicts. So with respect to fees obviously managers want to get paid as much as possible, clients want to pay as little as possible. The business has to make a decision as to where they want to calibrate that fee so that (a) it’s profitable on a long-term basis and the product can be maintained, they can invest in the right people, the right resources, the right systems, but at the same time to make the product attractive enough, and not detract so much from performance that clients will still invest and bring their money to us as a firm.
PRESENTER: You’ve got the regulator down there on your chart, what’s the regulatory risk and how can that be different from all the other risks that we’ve been talking about?
PABLO BALAN: The insurance and asset management industries are heavily regulated by the PRA, by the FCA and other smaller regulators. And it’s key that we ensure that we manage things in accordance to regulatory requirements. Some of them are very specific and very rules driven. Others are principles that are very broad, and subject to interpretation that you need to understand how the regulator comes about it, have close relation with the regulator, discussions about whether a particular decision that you’re making, or a particular asset that you’re investing in is in line or not with their expectations. And we regularly have these conversations with regulators to ensure that we stay on the right side of regulatory requirements. Obviously the regulators serve a critical role in ensuring that the industry as a whole is not just profitable but is managed in the best interests of clients and the financial system as a whole.
PRESENTER: Now your chart is headed importance of independence. Can you just tie in where the, from what we’ve discussed where the independence fits with that, and why that’s so important?
PABLO BALAN: So I’ll give you an example. M&G Prudential is coming together as a merger of two companies, an asset manager M&G and Prudential, the very old and established insurance company. And Prudential raises assets through insurance policies that in part gets invested in M&G. And so with those two businesses coming together under one roof, you’ve got conflicts of interest. Ideally from an M&G perspective they would want to manage as much as possible of the assets that Prudential own and manage on behalf of policyholders. And as a joint firm that might be the best way to maximise profits. But we’ve got to ensure also that we’re using the right managers for each asset class and that when we decide to invest with a manager we expect the best possible returns in those assets. So that conflict is one that’s quite clear and evident, and you’ve got a strong framework for managing those conflicts internally. And those frameworks, the conflict of interest frameworks are managed by teams of people in risk and compliance that have to be independent; otherwise they could be swayed one way or another by the people making the decisions.
PRESENTER: So we’ve talked through a lot in the course of the last half hour, but if there was one key takeaway for you on this whole topic of risk and what advisers should think about, how it’s managed in multi-asset portfolios, what would it be?
PABLO BALAN: I’d say that whoever you invest with it’s important that you look not just at the fund management side, the track record and how qualified they are, but it’s also important to look at the infrastructure, the institutional framework. Is this manager being supported by risk compliance teams that are ensuring that they’re managing the assets in the best interests of the client? Because you could have the smartest, best, most talented managers that were all subject to psychological behavioural biases. If in the wrong time, in the wrong circumstances even the best manager can fall prey to instinctive behaviours, and it’s just making sure that there’s people overseeing that process, to make sure that it’s done in a way that’s beneficial to clients in the long term.
PRESENTER: We have to leave it there. Pablo Balan, thank you.
PABLO BALAN: Thank you Mark.
PRESENTER: In order to consider the viewing of this video as structured learning, you must complete the reflective statement to demonstrate what you’ve learned and its relevance to you. By the end of this session you should be able to understand and to describe the different types of risk within a multi-asset portfolio; how you can monitor and manage risk in a multi-asset portfolio; and the importance of having a clear and independent risk framework. Please complete the reflective statement to validate your CPD.