A winning formula

Risk’s rising role in investment strategy

Risk.net surveyed 124 asset managers and hedge funds to explore the changing role risk offices play in the evolution of investment strategies, from early-stage product development through to portfolio management and re-evaluation, and the key financial, informational and technological challenges that must be overcome to achieve investors' objectives.

Survey results
A snapshot

High-performance investing

In 2020, investments are changing. So too is the investment process. Spurred by the harsh lessons of the financial crisis that began in 2007–08, and severely tested by today’s Covid-19-ravaged markets, institutional investors, insurers and asset managers of all stripes are bringing risk management principles – and innovation in risk data and technology – to their asset allocation and portfolio management processes sooner, and with greater sophistication than ever before.

Perhaps this was inevitable in the post-crisis period, with investors beefing up their chief risk office and enterprise risk functions. Today, risk-adjusted returns reign, while the buy side is also more closely tracking how its dealers manage flow and execution cost, and pass on the cost of capital, margin and even sell-side research – all as a result of new regulation. More is now affecting investment decision-making, and risk is clearly on the ascent.

However, there also are more recent drivers for the trend. Investment styles and considerations have evolved, as the record bull market run in the US and stimulative global prudential policy-making have forced investors to get creative in the search for yield. Meanwhile, new products have come to the fore as these stylistic waves rise and crest from one to the next. Above all, technological advances and the explosion of financial technology – known as fintech – have made it easier for firms to develop new datasets and models, add computing power and infrastructure on the fly, and integrate output across institutional functions seamlessly.

For many firms adjusting to today’s ‘new normal’, the question is not whether to amplify risk in the investment process – but where, how and by how much?

Risk.net set out to measure how institutional priorities combine with newly required outcomes, time horizons and even societal shifts such as geopolitical disruptions or climate change to make this organisational shift more rapid and consequential.

Querying a cross-section of risk and investment leaders across leading hedge funds and asset managers in the US and Europe, this research defined trends and identified contrasts in three areas:

  1. The influence of risk in investing – particularly pre-allocation
  2. The rise of factor-based modelling driving investment strategies
  3.  The growing interest in environmental, social and governance (ESG) approaches

In addition, the survey observed differences in opinion among risk and investment personnel to determine where perceptions might be split across functions, interviewing a range of senior risk and portfolio management leaders to provide additional insight into the findings.

The top-line results, examined in this report in detail, found that:

  • Risk teams, risk analysis and data are being introduced earlier in the investment process as styles and strategies evolve, and firms’ data and functional silos break down. There are, however, differing beliefs among risk and investment teams regarding why and how this is happening.
  • Firms are willing to run more ex ante risk analysis to deploy more downside risk protection and higher diversification.
  • Even as factor-based strategies gain more traction, firms admit many clients are taking a varied approach around the strategies and how they meet and calibrate their objectives.
  • Respondents are utilising factor risk models and deploying investment themes in combination.
  • A clear majority expects ESG to exert a growing influence in the next two years.

Risk moves up the starting grid

Examples abound in today's market of risk moving upstream. Investors are increasingly looking to hedge traditional portfolios or meet their mandates more creatively – or are at least exploring the possibilities. A wider array of products are in play, and are evolving quickly. In only a few years, exchange-traded funds have trended from ‘smart beta’ and liquid alternatives to cryptocurrency exposures to potential active non-transparent funds for 2020. The same can be said for new questions around ESG: how best to integrate beyond traditional exclusionary screens; how can it best be applied beyond equities to fixed income?

The work of the risk function has mirrored these changes. If colleagues were sceptical about planning for potential ‘green swan’ events, or the need to predict the global impact of a public health crisis in an emerging market, they are certainly paying attention now. These matters are newly relevant today because many institutions have widened the universe of investment options and introduced more complex objectives for their managers. Products, liquidity and timelines are different. And much of the data and knowledge required to accurately assess these possibilities will sit within risk or quantitative finance teams, rather than portfolio management.

The survey’s first findings speak to these priorities: for firms pulling risk into the investment process, downside risk mitigation is the main objective according to 44% of respondents, followed by diversification (34%) (see Question 1). Interestingly, however, these figures were roughly reversed among US respondents.

A primary takeaway from the interviews conducted is that risk is being moved into a more prominent role, earlier on – from ex post to ex ante. Where their input historically came after portfolio construction or asset allocation, today risk analysis is introduced as investment strategies are constructed. A healthy 95% said the risk team is always or often involved in the development of new investment strategies (see Question 2).

Likewise, among all strategies, the risk team is most likely to be involved for new strategies (40%) or those that are geographically/demographically specific (37%), while cost threshold (15%) or complexity (6%) are less important factors (see Question 3). For US respondents, risk was most likely to be brought in for geographically or demographically specific strategies.

Risk and investment
Fine-tuning needed?

On further analysis, a noticeable split was registered on these same questions, revealing an interesting diversity of viewpoints depending on a respondent’s role in the process. Some of these are fairly straightforward. For example, more than half of risk respondents to Question 2 (55%) believe they have an active role early on, whereas only one-quarter of investment personnel (26%) concur. In other words, there is a stronger self-perception among risk teams that their role is rising.

Other contrasts require a more nuanced explanation. Risk respondents were far more likely to have explored and delivered a wider range of factor-based strategies (51%) than investment teams (25%) (see Question 4). Risk sees a heavier lift. Likewise, and perhaps more puzzlingly, investment teams say risk mitigation was the primary driver, whereas risk personnel themselves pointed to diversification on this same question. Put another way: the investment side see risk performing essentially as a risk function; risk personnel, conversely, see themselves in the mix in service to an investment objective.

What explains these disparities? Some of these same opinions – and possible explanations – also played out in the series of interviews undertaken as a part of the research, as many firms are still at a point of exploration or incremental implementation for new strategies and themes. Most noted they have seen risk move up to ex ante activities; however, the actual deployment of new strategies is often undertaken on a ‘walking before you can run’ or a ‘carve-out’ basis, ultimately reflecting their clients’ prevailing preferences and appetites. And this could go some way towards explaining why risk teams –rather than investment teams – feel more aware of these changes.

That has its own consequences for risk technology too, and most interviewees said their own platforms – or those of their platform providers – were in the middle of transformation for these same reasons.

In the wider world, technology has gone mainstream, part of a generational change ushered in by the pioneers of the early 2000s. Not all survived but, as the technology behind the innovations that fuelled the dotcom boom has become more commonplace and easier to access and implement, other sectors have been able to harness it successfully for longer-term growth. 

Today’s asset managers and hedge funds – the newest staff and clients of which have grown up in a tech-enabled world – cannot afford to be left behind. Sophisticated data technology and analysis are needed to challenge conventional models, capture new signals among the noise and manage risk effectively in an increasingly complex investment landscape. The tech needs to be able to carry the load and be deployed flexibly and at scale.

Risk’s changing role in investment strategy

Interview with Enrico Massignani, head of risk, Generali Group Investment, Asset and Wealth Management

00.50 Introduction to investment strategies

02:10 Risk’s role in the investment process

05:30 Covid-19 impact on strategy and operations

09:00 Evolution of risk culture and language

13:10 Risk and investment team collaboration

15:58 Using risk analytics and data to your advantage

Risk factor model development
Focus and challenges

Next, the survey examined a pair of blossoming areas in which the investment process and risk intersect. The first is a prime example of the shifts and piecemeal approach previously highlighted: factor models in investment decision-making. Factors have been around for decades, but their visibility has grown mightily as more risk-based, indexed or hybrid strategies have gained popularity. Many investors are now dipping their toes in the water, or eyeing a bigger play.

The research began with the view that the evolution and adoption of the factor risk model is tied directly to the rise of the role of risk in the investment process. Risk.net next dug into factor-based investing a bit further – the particular factors that are most risk-relative, how firms are packaging them today and the issues surrounding their management from a risk perspective.

By far the most significant factor in terms of risk’s involvement was momentum (34%) (see Question 5). At the opposite end of the scale, stylistic (9%) and quality (8%) factors were seen as the least risk-intensive. Another set of responses was reasonable, given the discussion about early/piecemeal implementation: the highest priority in packaging factors is the ability to calibrate and adjust exposure (31%) or assets owned – which will have significant consequences for the liquidity requirements and time horizons in play and, ultimately, their applicability (see Question 6).

Interestingly, results focusing on the challenges faced by risk assessment around factors played out slightly differently. Comparable/usable risk decomposition techniques (78%) were seen as the main operational challenge associated with managing factors within respondents’ enterprise risk frameworks, followed by integration of new evaluation approaches (64%), with incompatible portfolio management systems (53%) also featuring strongly (see Question 7). Solving for each of these is of paramount importance.

“Sometimes, you’re asking a client to move away from an index or something they understand,” said Altaf Kassan, head of investment strategy for Europe, the Middle East and Africa at State Street Global Advisors. “You might say no-one has ever been fired for going into a simple index strategy but, when they suffer relative to the old benchmark with factors or smart beta, they’ll want to know why or why not. These are challenging conversations. How long underperformance lasts and how deep underperformance can be, relative drawdowns and underperforming market cap. Even though we talk about standardisation around factors, there are still differences in interpretation. As an investment manager, you have to be ready to get drawn into those kinds of debates.”

And indeed, to that point, what is most interesting is that all three of these challenges represent a kind of operational lag: firms want to be able to deploy factors (even incrementally) for clients, while each would present technological challenges on the back end that may hinder those ambitions.

Building the factor toolkit

Given these operational challenges, a logical next question lies in how firms are developing platforms and process to incorporate factors more effectively. There were several notable splits on these elements as well, this time by geography.

To begin with, many firms' focus seems to be on a handful of specific factors rather than taking a more standardised, top-down evaluation approach – but that is less so the case in the US. While only 22% of overall respondents to Question 5 said they look across factors with a standard process, that number in the US jumped to more than one-third (37%), and was much lower in other regions.

A similar geographic inflection is identified in the way firms prefer to build out their factor modelling programmes. Almost half (45%) said they exclusively use third-party models, compared with one-third (32%) preferring a proprietary build in-house, and 21% using a mix of both (see Question 8). The number using a hybrid approach drops to just 9% among US firms.

A more even spread was seen among firms’ analytics and investment tools. Here, 43% said they develop these in-house, versus one-quarter (26%) using third parties only – and around three in 10 (29%) using a combination of both. Firms were more likely to favour in-house development in the US market (see Question 9).

The overall takeaway here is that there is no single correct approach to factors. US-based firms appear to take a more comprehensive, and more black-box type, approach to the tech aspects of their programme, while those in Europe are more likely to be selective in their approach – but less proprietary in how they build.

As one US-based risk technologist put it: “Everyone in investment management does [factors] in their own way. There are those bigger managers with hedge funds inside, for instance. Those teams inside may do something very specific to the strategy, whether enhancing existing tools or models or building their own.”

ESG accelerating

Unlike factors, which have slowly and steadily made their way towards the mainstream, the second area of analysis – ESG adoption – has arrived fast and furious. After gaining increased global attention and significant inflows in recent years, we sought to explore how ESG is incorporated into the evaluation process, and the approaches firms are taking.

First, there is ESG’s level of influence. Overall, 98% of respondents are using ESG in some form (see Question 10). Nearly 30% reported that ESG has a significant influence on the risk management of portfolios. The majority (59%) said they have incorporated it where most appropriate and continue to explore the area. A few (10%) said they implement in response to client requests and only 2% said they are doing nothing with ESG.

Looking ahead, we also asked respondents about their plans for ESG. The majority (76%) expect it to have an increasing influence in the next two years, compared with 14% who believe it will decline, and 9% who see it staying steady (see Question 11). In short, while the majority of firms today are using ESG for select projects, it seems many firms see it playing an increasingly influential role in the future.

Several other interviewees noted the potential connection between factor-based investing and ESG – that this area is certain to expand in importance. While the majority of respondents expressed a desire to do more on ESG over the next few years, some highlighted challenges to full integration, such as a lack of standards, a need for more data and better frameworks. Respondents pointed to the development of traditional factor-based investing as a potential model going forward, and would explore this area more as evidence for ESG and alpha grows.

Risk in the driving seat

In aggregate, the findings from the Risk.net survey paint a fascinating picture of risk’s changing role in the investment process. For many asset owners and investment managers, we see these two areas integrating, perhaps even converging, over time as diverse risks – be they traditional factors or new ESG considerations – layer into more and more investment decisions, and the data used to evaluate those decisions continues to expand. It remains an open question as to how these functions – and perceptions among their team members – evolve as a result.

For now, many firms appear content to let the market dictate the terms of their engagement: those we spoke to universally agreed that factors often need an extended window to prove out, so they are always going to move steadily rather than spectacularly.

ESG, on the other hand, continues its growth unabated. It may be up to risk teams to collaborate across the industry as it matures and develop common frameworks and standards – in much the same way credit risk and ratings did decades ago.

Whatever the level of enthusiasm today, the results do make clear that firms must consider their own plan for risk data and tech transformation for the future. Investors need to strategise and spend now or risk running behind that big institutional client’s bump in factor allocation, or the next new direction for constructing an ESG portfolio.

As is often the case, it is about having the capability, technology and tools in place. Increasingly, those elements must reflect changing contours of contemporary themes and enterprise requirements and, above all, bring risk and investment teams together.

About the survey

Risk.net sought the views of a cross-section of senior risk and investment professionals from the top 200 asset managers and hedge funds in the US and Europe. The results and comments in this analysis are drawn from a total of 124 valid responses to the online survey and eight in-depth phone interviews.

Respondent profile

About MSCI

MSCI is a leading provider of critical decision support tools and services for the global investment community. With over 45 years of expertise in research, data and technology, MSCI powers better investment decisions by enabling clients to understand and analyse key drivers of risk and return, and confidently build more effective portfolios. MSCI creates industry-leading research-enhanced solutions that clients use to gain insight into and improve transparency across the investment process.