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Global Institutional Consulting Chief Investment Office An Investor-Centric Approach to Risk Budgeting FEBRUARY 2017 Emmanuel D. Hatzakis Director Traditionally, an institution sets risk and return goals for its investment portfolio that it believes will help it succeed in its mission. Risk budgeting can be an integral part of institutional investment management, and we believe our systematic process known as the Institutional Resource Allocation Framework can help an institution better understand, quantify, attribute and allocate risks within its portfolio to improve the institution’s ability to succeed in its mission while minimizing the risk of loss. In this whitepaper, we outline the Institutional Resource Allocation Framework, which places the investor, and not the markets, at the center of the investment management process. Our framework marks a departure from the traditional approach to risk budgeting, which has tended to focus on the more academic aspects of risk without considering the outcomes and their effects on investors’ goals and needs. The Institutional Resource Allocation Framework Asset Category Protective Market Strategic Need addressed To provide cash flows, as much and when needed, for an institution to function effectively in the near term. Invest to maintain spending needs over the longer term. Potential for significant growth in assets and impact, relative to its peer group. Risk type Operational risk that could jeopardize an institution’s basic operations Market risk that comes from investment exposure to financial markets (the widely known dimension of risk) Strategic risk that assets earmarked for future organizational growth fall short of their desired growth target Examples • Cash (emergency fund) • Certificates of Deposit (CD) • T-bills/notes • Equities: Broadly diversified size/style/ sector exposure • Fixed income: Credit quality and duration diversification • Cash (reserved for opportunistic investing) • Diversified alternative investments • Concentrated stocks and bonds • Patents • Certain private equity funds • Ownership stakes in companies • Direct real estate Risk-return characteristic Often lower risk, but low return Risk and return in line with market performance High risk, but with the potential for above-market returns Benchmark Inflation: Protective assets are expected to help reduce downside risk and provide potential safety. Risk-Adjusted Market Return: All traditional Absolute Return or Mission-Related: portfolio performance measures are Strategic assets are intended to significantly applicable for market assets. outperform the market if and when they succeed, or to serve the organization's strategic goals and advance its mission. Bank of America Merrill Lynch is a marketing name for the Global Institutional Consulting business of Bank of America Corporation (“BofA Corp.”). Banking activities may be performed by wholly owned banking affiliates of BofA Corp., including Bank of America, N.A., member FDIC. Brokerage services are performed by wholly owned brokerage affiliates of BofA Corp., including Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S”), a registered broker-dealer and member SIPC. Investment products offered through MLPF&S: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value Bank of America Merrill Lynch makes available investment products sponsored, managed, distributed or provided by companies that are affiliates of BofA Corp. or in which BofA Corp. has a substantial economic interest. Please see important disclosure information on the last page. An Investor-Centric Approach to Risk Budgeting | 2 Each institution is different, and has unique goals and needs Institutional investors include philanthropic organizations, endowments, pension plans, charitable trusts and trust funds created through legal settlements, to name a few. Institutional investors are stewards of the assets of a class of beneficiaries, and often have a fiduciary responsibility for managing these assets on the beneficiaries’ behalf. Each institutional investor is unique in terms of its needs and goals, which in turn are based on the needs and goals of its beneficiaries. To succeed in its mission, an institution may rely solely on its endowed asset base, or on both its endowed asset base and other sources, which, depending on its type, could include donations, tuition revenue (for educational institutions), or more funding categories. Some institutions are set up to fulfill their mission in perpetuity, while others are designed to deplete their asset base over a number of years or once they have fulfilled their mission. While institutions may differ in their approach to risk management1, they all focus on process and standards of prudence2. A risk budgeting process, robust but flexible enough to accommodate each organization's special characteristics, is crucial in helping achieve the organization’s goals and succeed in its mission. Exhibit 1 outlines our risk budgeting process flow for institutional investors. The first column of Focus Box 1, on the next page, introduces four case studies of institutions and their missions, which the institutions expect to fully or partially fulfill through returns on their invested assets. An institution would be well-served to address the following questions: • Which types of risk are appropriate for the organization? • What should be the degree of exposure to each type of risk at any time? • How can risk exposures be managed over the organization’s time horizon? The second column of Focus Box 1 outlines some of the common risks that each of the case-study institutions faces in managing its portfolio to fulfill its mission. Our investor-centric approach produces guidance that is relevant and intuitive, and establishes metrics that enable both rigorous ex-ante specification and allocation of risk exposures, and unambiguous ex-post evaluation, measurement and attribution of investment outcomes3. We believe that this can help strengthen the relationship between the investor and investment advisor by facilitating agreement on investor goals to be addressed, and how the management of portfolios can help address these goals through a disciplined management of risk exposures, thereby increasing confidence in the effectiveness of investment policies and their outcomes. Exhibit 1: Risk Budgeting Flow Chart • Spending GOALS (support mission for current generations) RISK BUDGETING BODY • • Board Investment Committee MISSION • Healthcare • Education • Social • Religious • Retirement • Portfolio Growth (future generations’ support) • Shortfall FUNDING STATUS (evaluate and adjust goals and, if appropriate, allocate more to asset classes and types with higher expected returns) • Surplus (enables more goals with long-term impact) Source: Chief Investment Office and U.S. Trust. Brown, A. 2013. “Risk Management for Pension Funds and Endowments,” chapter in book: Global Asset Management: Strategies, Risks, Processes, and Technologies, edited by M. Pinedo, I. Walter, Palgrave McMillan Publishers, September. 2 Mangiero, S. 2012. “Pension Risk Management: The Importance of Oversight,” Society of Actuaries, Risk Management, Issue 26, December. 3 U.S. Trust. 2009. “Think Forward, Act Now: Wealth Management for the New World,” Capital Acumen, Issue 13, Fall. 1 An Investor-Centric Approach to Risk Budgeting | 3 Focus Box 1: Risk Budgeting: Four Case Studies* * Situation Necessary common risks A museum endowment portfolio makes distributions in accordance with a defined spending rate. The portfolio is reasonably well diversified but is invested primarily in long-only financial assets. The life of the portfolio is infinite. Trustee interests can become focused on current needs, particularly as they pertain to covering shortfalls in the current operating budget. Trustees may allow their personal investment philosophies to interfere with the endowment being invested appropriately for its purpose (to meet its mission). The endowment’s purpose and expected life should drive the investment strategy that can better support the appropriate spending policy. The asset allocation should be sufficient to balance near- and long-term needs. The liquidity strategy (protective assets) should enable trustees to feel comfortable investing in less liquid strategies (primarily strategic assets, but also market assets) that are expected to add incremental returns to the portfolio over time. A settlement trust will be funded with a single cash contribution. Distributions are expected to follow a predetermined schedule, but the trust’s management is expected to grow the trust’s value. The life of the portfolio is 10 years. A traditional portfolio construction process, designed to protect principal, may not provide the scheduled cash outflows needed to fund the trust’s mission without eroding the trust’s value unreasonably in periods of market volatility. The investment strategy should support a spending policy consistent with the trust’s purpose. The asset allocation should satisfy liquidity needs. Funding to match liabilities may be appropriate in some cases. The growth strategy should be subordinate to the liquidity strategy, which would imply a greater emphasis on protective assets than on market and strategic assets. A healthcare conversion foundation was established with the proceeds from the sale of a community hospital. There is no precedent for spending needs. Local community leaders serving as trustees have a strong sense of stewardship for the assets. The terms of the sale of the hospital must be met by the foundation’s portfolio over the near term. Trustees’ strong sense of responsibility to safeguard the assets may cause the trustees to forsake the foundation’s investment strategy during periods of significant market volatility. Healthcare inflation presents a greater-thannormal risk to the long-term purchasing power of the assets. Potential growth, and aging, of the community could increase demands on the foundation. Separate investment strategies should reflect the two phases in the life of the foundation. The initial portfolio should focus on meeting the terms of the trust and on allowing the trustees to develop a level of comfort overseeing the assets. The subsequent strategy is likely to incorporate the wide array of investment asset classes that we use normally to diversify a portfolio, including alternative investments. The early stage of the relationship should incorporate education to prepare the trustees for investing in assets about which they are less knowledgeable or feel less comfortable. A private foundation has received a bequest of real assets (oil and gas properties) that amounts to 60% of its total portfolio. The foundation must distribute 5% of assets annually, so income from the properties is attractive. The bequest was made by the patriarch of a local family who has made its fortune in oil and gas and who might give additional assets to the foundation if he is pleased with how the foundation manages assets. Gifts of real assets can make portfolio diversification difficult, due to the assets’ illiquidity or the trustees’ reluctance, due to concerns that the donor may not approve. Assets that generate high levels of income may be viewed as “sacred” regardless of whether they represent a concentration risk within the portfolio. In the case of oil and gas properties, the underlying volatility of the commodity can lead to a “we can’t sell this now” mentality both when prices are relatively high and when they are relatively low. Understand whether the foundation has distribution goals that may exceed the 5% required distribution for a private foundation. Perform a spending policy analysis to develop a target strategic asset allocation. Develop a liquidity (protective asset) strategy that will reduce the need for income. Develop a diversification (market asset) strategy that allows the portfolio to move toward proper diversification in a timely manner. These case studies are for illustrative purposes only. Potential strategies An Investor-Centric Approach to Risk Budgeting | 4 The Institutional Resource Allocation Framework An institution’s mission defines its needs and goals, most of which have to be fully or partially supported by investment returns. Institutions have short- and long-term needs and goals and ought to find the right balance in serving both4, 5, 6. The Institutional Resource Allocation Framework sets guidelines on how this can be accomplished: 1. Protective assets: An institution needs adequate liquidity to fund its near-term goals and operating expenses. To serve that purpose, protective assets are structured in a way that minimizes the pain of short-term loss from market movements. Accordingly, the assets are generally invested in low-risk, but also low-return, financial instruments such as cash equivalents and short-duration bonds collectively referred to as protective assets. This bucket of assets helps to smooth out volatility so that the short-term needs of current beneficiaries can be met without being impacted by market drawdowns. But, institutions need to ensure that they do not overallocate to protective assets, as they may not provide the returns necessary to meet the organization’s intermediate- to longer-term needs. 2. Market assets: To provide for future liabilities and intermediate- to longer-term spending needs, especially in the presence of inflation, an institution may have to take on systematic risk and maintain exposure to market risk through market assets. To earn the higher return from the risk-return tradeoff, this asset bucket can include diversified exposure to equities, fixed income, and alternative investments, which include hedge funds, private equity, real estate, and commodities. Exposure to these asset classes and types could also be gained through structured products. A mix of traditional passive (market capitalizationweighted), enhanced-index, and alternatively weighted, e.g., factor-focused7, managers or strategies, as well as reasonably diversified long-only truly active8 managers who run concentrated portfolios, could belong to this bucket9. Portfolios of such assets should be well-diversified (which may help reduce idiosyncratic risk to reward risk exposures) and efficient (to help them target the highest expected return for the level of market risk exposure) to improve the probability that the organization will meet its intermediateto longer-term needs. 3. Strategic assets: For an opportunity to achieve a significant surplus that could help an institution transcend its mission, grow its impact, and surpass its peer group, it may consider exposure to strategic assets. Concentrated investment exposures to hedge funds, private equity, and real estate, patents, and direct ownership stakes are examples of the many asset types than can serve this purpose. Concentrated stock and bond positions, if they pre-exist in a portfolio, must be carefully managed so as not to contribute excess risk. Exposure to strategic assets aims for above-market performance, but may not always achieve a positive return. Such exposure, intended to significantly outperform the market, entails higher risk. If some of the worst possible outcomes materialize, losses can be severe enough to cause the institution to miss its growth targets. Such a shortfall can be proportional to the magnitude of the exposure taken, so the opportunistic portfolio must be carefully sized, diversified, and monitored so that the protective and market assets are sufficient to fulfill the organization’s mission. Merrill Lynch Global Institutional Consulting. 2015. “Beyond Liability Driven Investing,” whitepaper, Summer. U.S. Trust. 2014. “The Endowment Challenge: Supporting nonprofit missions with goals-based investment strategies.” 6 U.S. Trust. 2015. “Spending Policy: A key component to meeting financial goals.” 7 Goldman Sachs Asset Management (GSAM) Perspectives. 2014. “Is some beta smarter than others?” December. 8 Cremers, M.K.J, and A. Petajisto. 2009. “How active is your fund manager? A new measure that predicts performance,” Review of Financial Studies, 22(9):3329-3365. 9 Alford, A., R. Jones, and K. Winkelmann. 2003. “A Spectrum Approach to Active Risk Budgeting,” The Journal of Portfolio Management, pp. 49-60, Fall. 4 5 An Investor-Centric Approach to Risk Budgeting | 5 Expected Return Exhibit 2: Conceptual Framing of Institutional Resource Allocation Portfolios Cap ita l rk Ma et L Concentration Risk Protective Assets Sub-portfolio Market Assets Sub-portfolio Survey Average Endowments over $1bn 36% 17% 31% 13% International 19% 18% Fixed Income 9% 8% Alternatives 51% 57% 4% 4% 100% 100% Equities Domestic ine Efficient Frontier Risk-Free Rate Exhibit 3: Asset Allocation for U.S. Colleges and Universities, 2014 Strategic Assets Sub-portfolio Source: Chief Investment Office and U.S. Trust. Exhibit 2 provides an illustrative view of where the protective, market, and strategic asset sub-portfolios could reside on the two-dimensional space of expected return and risk. Allocations of asset classes and types to each bucket are determined, among other things, by the nature and size of the institution and the role its investment portfolio plays in its funding process. For example, some institutions depend on their portfolio to a greater degree than others for some of their strategic initiatives and long-term goals; these institutions must have higher allocations to market and strategic assets. Larger institutions enjoy better access to some of these types of assets than smaller ones, and therefore can have higher allocations to the market and strategic asset buckets, and to assets that fit more naturally in each of these buckets. See, for example, in Exhibit 3, the higher allocations to alternatives in university endowments larger than $1 billion compared to the averagesized endowment10. The third column of Focus Box 1 on page 3 presents potential strategies for each of the case-study institutions to use in managing its portfolio to better serve its mission and balance the interests and needs of its current and future beneficiaries. Short-Term Securities/ Cash/Other Total Source: National Association of College and University Business Officers (2015), Commonfund Institute, Chief Investment Office and U.S. Trust. Volatile markets and evolving investor goals and needs call for a robust risk allocation framework Investing involves risk. Managers, who have a quantitative view of risk, tend to think of risk budgeting as a part of the portfolio management process that adds analytical rigor to it, or as a way to “identify, quantify, and spend risk in the most efficient manner possible11.” The most common definition of risk is volatility, which is generally understood as deviation from expected return12. While institutional investors tend to think of risk as potential mission failure13, they often equate volatility only with its bad outcomes — asset price declines. But when volatility causes returns to be higher than expected, it gives investors the opportunity to participate in the upside of rising markets and asset prices. The secret sauce in managing assets is striking a balance between benefitting from volatility and avoiding being hurt by it, to improve the probability that the institution fulfills its mission. As investors’ goals and needs evolve over time, a robust asset allocation process that positions portfolio risk exposures to achieve the highest likelihood of being rewarded could provide adequate returns in a dynamic market environment14. National Association of College and University Business Officers and Commonfund Institute. 2015. “2014 Study of Endowments.” Idzorek, T.M. 2008. “Risk Budgeting — Where Do You Spend Your Risk?” Morningstar presentation. 12 Martellini, L., V. Milhau, and A. Tarelli. 2015. “Toward Conditional Risk Parity: Improving Risk Budgeting Techniques in Changing Economic Environments,” The Journal of Alternative Investments,” pp. 1-18, Summer. 13 U.S. Trust. 2014. “Addressing Risk from the Client’s Perspective: A more insightful approach to managing nonprofit organizations’ investments.” 14 U.S. Trust. 2008. “More Eggs, Better Baskets.” 10 11 An Investor-Centric Approach to Risk Budgeting | 6 Short-term risk budgeting The top short-term financial risks for an institutional portfolio are liquidity and volatility risk: 1. Liquidity risk is the lack of resources to meet immediate financial obligations, either due to inadequate liquid assets, or an inability to borrow at reasonable interest rates or at all. Liquidity risk management in order to meet the organization’s short-term needs can be accomplished in the following ways: 2. Inadequate long-term asset-liability matching or coordination between an organizations’s funding sources and spending policy. This could result from: a. Mismatches between investment strategy and spending plans a. Harvesting the portfolio’s interest, dividends, and distributions b. Reliance on standard portfolio risk metrics for long-term return goals, e.g., volatility should not play a role in longterm allocation decisions, as its proper role is as a metric for short-term portfolio risk b. Liquidating the short-term, high-quality fixed income securities of the portfolio c. Poor planning to deal with the effect of sharp portfolio drawdowns on the future path of returns c. Rebalancing the portfolio to target allocations d. Underestimation of future spending needs, especially when expected and unexpected inflation is not properly factored into investment and spending plans An organization’s liquidity analysis should include external sources of funding, such as donations, tuition revenue (for educational institutions), and borrowing. 2. Volatility risk refers to an institutional portfolio’s risk of short-term market returns that fall short of the return expectations based on assumptions for the asset classes in the portfolio. Protective assets can be allocated to securities that can help reduce this risk. Long-term risk budgeting Long-term risks are those that threaten the long-term success of the organization in fulfilling its mission. The key long-term risk for an institution is its inability to meet its liabilities and spending needs beyond the next few months and years. This could be the result of several factors, including: 1. Insufficient long-term return portfolio growth due to allocations to asset classes and securities that are perceived as conservative, because they are less volatile, but are not expected to generate enough return to provide this needed portfolio growth. For that purpose, market and strategic assets ought to be significant parts of the portfolio. e. A weak or non-existent strategy to obtain robust external funding sources In order for an institution to deliver on its mission, it needs to strike a balance between investing in relatively low-risk, but lower-returning, assets to meet its current spending needs and fulfill its near-term goals, and investing in riskier assets to earn higher market returns over time to grow the assets to meet future needs, obligations and the institution’s vision. Institutions are encouraged to explicitly consider their short-, intermediateand long-term goals to better align their resources to improve the probability of meeting all of their goals. Irrespective of the diversity of institutions, there are two requirements for any portfolio: the ability to meet current spending needs and long-term growth targets. Timing and amounts of cash outflows, and the expected portfolio growth profiles, may differ, but these two broad dimensions underlie the foundation of our risk allocation framework. An Investor-Centric Approach to Risk Budgeting | 7 The dynamic nature of risk budgeting The policy portfolio represents an institution’s long-term allocation of risk to the various asset classes. Since it changes slowly, it tends to be viewed as static and forms the baseline strategic risk budget, subject to periodic review by the institution’s board or investment committee. The realized risk in an institutional portfolio rarely equals the baseline risk budget. This is because markets are not only volatile, but also evolving through time. Also, taking tactical tilts from the policy portfolio necessitates deviations either above or below the baseline risk. By the static view of risk budgeting, deviations from the baseline must be reviewed and corrected so the portfolio is back in compliance with the policy guidelines. Taking a dynamic view, in addition to their diagnostic role, deviations can also serve as opportunities for the institution’s board or investment committee to rethink its portfolio allocations and adjust its risk budget tactically, or even drift to a new baseline that better positions its portfolio to help it meet its liabilities and realize its long-term goals. This can go beyond the quantitative apportionment of risk to existing asset classes and types, and encompass investments that had not been previously considered, or even from outside the standard investable universe. For example, some universities may invest in patents or local startups, which, while subject to their own unique risks, could offer benefits beyond portfolio returns, such as promoting innovation and creating employment. Conclusion An institution can use the Institutional Resource Allocation Framework as an integral part of its risk budgeting process to help it better understand, quantify, attribute and allocate risks as it tries to ensure its portfolio helps it meet its short- and longterm goals and ultimately succeed in its mission. The framework can help an organization align its resources so as to minimize the magnitude of investment losses and their impact on its ability to meet immediate goals. It also can help an organization establish an investment approach to fund longer-term goals or enhance its resources or mission. Along with external funding sources and a carefully planned spending policy, the Institutional Risk Allocation Framework can provide a useful investment tool for institutions. Alphabetical List of References 1. Alford, A., R. Jones, and K. Winkelmann. 2003. “A Spectrum Approach to Active Risk Budgeting,” The Journal of Portfolio Management, pp. 49-60, Fall. 2. Brown, A. 2013. “Risk Management for Pension Funds and Endowments,” chapter in book: Global Asset Management: Strategies, Risks, Processes, and Technologies, edited by M. Pinedo, I. Walter, Palgrave McMillan Publishers, September. 3. Cremers, M.K.J, and A. Petajisto. 2009. “How active is your fund manager? A new measure that predicts performance,” Review of Financial Studies, 22(9):3329-3365. 4. Goldman Sachs Asset Management (GSAM) Perspectives. 2014. “Is some beta smarter than others?” December. 5. Hatzakis, E.D. 2015. “Redefining Indexing Using Smart Beta Strategies,” Merrill Lynch Global Institutional Consulting whitepaper, September. 6. Idzorek, T.M. 2008. “Risk Budgeting—Where Do You Spend Your Risk?” Morningstar presentation. 7. Kumar, A., L.P. McKay, A.K. Sharma, and A.S. Kohli. 2014. “Smart Beta or Transparent Alpha?” Investment Strategy: Global Portfolio Solutions and Institutional Investments Report, U.S. Trust. 8. Mangiero, S. 2012. “Pension Risk Management: The Importance of Oversight,” Society of Actuaries, Risk Management, Issue 26, December. 9. Martellini, L., V. Milhau, and A. Tarelli. 2015. “Toward Conditional Risk Parity: Improving Risk Budgeting Techniques in Changing Economic Environments,” The Journal of Alternative Investments,” pp. 1-18, Summer. 10. Merrill Lynch Global Institutional Consulting. 2015. “Beyond Liability Driven Investing,” whitepaper, Summer. 11. National Association of College and University Business Officers and Commonfund Institute (NACUBO). 2015. “2014 Study of Endowments.” 12. U.S. Trust. 2008. “More Eggs, Better Baskets.” 13. U.S. Trust. 2009. “Think Forward, Act Now: Wealth Management for the New World,” Capital Acumen, Issue 13, Fall. 14. U.S. Trust. 2014. “Addressing Risk from the Client’s Perspective: A more insightful approach to managing nonprofit organizations’ investments.” 15. U.S. Trust. 2014. “The Endowment Challenge: Supporting nonprofit missions with goals-based investment strategies.” 16. U.S. Trust. 2015. “Spending Policy: A key component to meeting financial goals.” Bank of America Merrill Lynch can assist you with today’s more complex financial markets. Our Global Institutional Consultants can work with your organization to help you meet the demands of institutional investing. To learn more about Bank of America Merrill Lynch Global Institutional Consulting, visit us at http://www.baml.com/ Institutionalconsulting or e-mail us at [email protected]. An Investor-Centric Approach to Risk Budgeting | 8 CHIEF INVESTMENT OFFICE Christopher Hyzy Chief Investment Officer Bank of America Global Wealth and Investment Management Mary Ann Bartels Karin Kimbrough Niladri Mukherjee Head of Merrill Lynch Wealth Management Portfolio Strategy Head of Investment Strategy Merrill Lynch Wealth Management Director of Portfolio Strategy, Private Banking & Investment Group (PBIG) and International Tony Golden Emmanuel D. Hatzakis Marci McGregor Rodrigo C. Serrano John Veit Director Director Director Vice President Director This material was prepared by the Global Wealth & Investment Management (GWIM) Chief Investment Office and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of the GWIM Chief Investment Office only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available. This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client’s investment objectives, risk tolerance, liquidity needs and financial situation. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. 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