The Investment Risk Function and its Importance in Asset Allocation

Amid heightened competition in the market, asset allocators are intensifying their scrutiny of all aspects of investment firm’s capabilities, including an increased focus on the investment risk function of a manager. Gone are the days when assets were allocated solely based on historical performance. Now, an understanding of the robustness, sophistication and independence of an investment risk management and oversight function is influencing allocation decisions. A well-functioning investment risk oversight function can increase investor confidence, improving client retention and acquisition. Firms should have a clear definition of investment risk, and the individuals within the investment risk function should have the skillset and knowledge akin to that of the investment decision makers themselves.

Independence of the investment risk oversight function from the investment decision makers (first line) is essential. This investment risk function should have the authority, knowledge, tooling, and visibility to provide educated challenge to portfolio managers. It requires individuals who are well-versed in diverse investment risk methodologies and an agile risk framework to incorporate new asset mixes and classes as the firms product service offering evolves and scales.

The appropriate flow of market data to produce comprehensive actionable risk analytics is also vital. This can enable the investment risk function to be proactive to market events, protecting investors and facilitating better investment outcomes. An effective oversight function should also have the ability to enable the first line to concentrate on achieving favorable return outcomes by handling any mandatory regulatory risk reporting while providing consistent risk analytics to the investment committees, and executives within the firm

It’s imperative that the analysis and monitoring of investment risk is embedded into the culture and technology of an investment firm, beyond the simple reactive requirement for governance. Utilizing automation, AI and a developing technology and data landscape, investment firms can effectively build investment risk into their operating model. This begins with the effective governance of new mandates, and building controls into the pre and post trade lifecycle of a fund.

One of the biggest drivers of favorable investment outcomes is determining the appropriate fund or model asset class allocation. Allocators are increasingly moving away from the traditional 60/40 Equity bonds split and are turning to more creative ways to diversify and limit risk in portfolios. Many are looking to gain diversification through alternative assets, such as private equity/credit and real estate funds. This adds more complexity for the investment risk function due to the understated risk (volatility) and correlation of these asset classes, derived from the smoothed appraisal data used to determine the historic fluctuation in price movements. The investment risk function must adopt their framework and tooling to account for this trend, particularly as the market directs more investment toward these asset classes.

Managers should ensure transparency regarding their approach to portfolio management and their value proposition compared to a passive fund with a similar mandate. Whether the model portfolio or investment fund is constructed using a top-down or bottom-up approach, or employs a fundamental or quantitative strategy, significantly influences how the firm should manage and measure risk exposures. For a fund using a bottom-up fundamental approach, risk management may involve implementing a strategy that mitigates idiosyncratic risk by reducing concentration in any single position. Conversely, a systematic top-down approach, may focus more on measures such as, Value at Risk (VaR) to manage the risk exposure of the fund. Nuances such as this demonstrate the breadth and depth of knowledge, data, technology and process required to be an effective investment risk oversight function.

An effective investment risk function can act as a driver for competitive advantage for investment firms making them a more attractive option for asset allocators. The challenge for firms lies in making sure that the investment risk function is sophisticated enough to drive sustainable growth and oversight, whilst not inflating the cost to serve. It is therefore essential for investment firms to proactively focus on enhancing their investment risk function through embedding scalable technology and data operating models, alongside a robust governance structure to ensure they meet their strategic objectives amidst a rapidly evolving market and a more sophisticated investor base.