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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.
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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
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