Noël Amenc, Professor of Finance, Director of the Edhec Risk Institute

‘’Regulators are leading to forget dynamic and systematic risk budgets management ’’

le 02/12/2010 L'AGEFI Hebdo

You had previously explained the limits of diversification for managing asset and liability management risks. Do you offer some solutions for institutional investors, faced with ever increasing prudential and accounting regulatory constraints, to take account of the risks and problems of financing their liabilities?

For several years the Edhec Risk Institute has defended the idea that risk management could not be limited to diversification, but should take account of the hedging or insurance dimensions of asset and liability risks. We have shown that diversification enables investors, over the long term, not only to improve the risk-yield combination of the performance portfolio but also to reduce the opportunity cost of risk control techniques which are the only way of ensuring compliance with solvency constraints or the financing ratio of an insurance company or a pension fund. However, this approach can be extended to the management of corporate pension funds by taking into account not the sub-financing risk of only the pension fund but by taking account of the joint probability of default of the fund and the sponsor company; this makes it possible to optimise the value of the latter’s contribution and the former’s refinancing needs. In addition, issuers and investors would benefit from the development of inflation-linked corporate bonds. This research has considerable potential in a context where government bonds of OECD countries are no longer perceived, since the crisis, as essential assets for the liability risks hedging portfolio.

You have criticised regulators for their lack of understanding of the investment sector’s risks. Do you think that the crisis has changed things?

Unfortunately not. By focusing on measuring extreme risks and their diversification, the regulator is leading industry players to forget the basic essentials, namely the dynamic and systematic management of risk budgets. We have shown that European pension funds have a truncated vision of risk management, which leads not only to under-optimal allocations in risky assets but also to too much confidence being placed in econometrics and the measuring extreme risks, to the detriment of approaches based on controlling or assuring risks which are not favoured by international prudential and accounting regulatory frameworks.

Similarly, in our opinion, the industry and regulators do not seem to have fully learnt the lessons of events as important in terms of non-financial risks as Lehman’s bankruptcy and the Madoff fraud.

Moreover, what are the main conclusions of your work on passive management?

The main conclusion of our work presented at EID (Edhec Institutional Days) 2010 is that a lot still remains to be done in the field of passive management. Although professionals and investors as a whole agree on the advantages and the development of this type of management, which the results of the 2010 annual survey on the use of ETF confirm, it is important to emphasise that passive investment is still, in our opinion, under-optimal because it relies too often on market indices which are not good benchmarks and do not enable investors to benefit from the normal remuneration of the risks that they take. Whether they are cap-weighted equity indices or debt-weighted bond indices, the most popular passive management benchmarks are inefficient and particularly risky. From this point of view, EID 2010 provides an opportunity to take stock of alternative benchmarks and the way in which investors perceive these new offerings, with an exclusive survey which, we can already say, confirms a clear trend away from any cap-weighting for equity management and real concerns regarding the risk concentration of traditional bond indices.

Finally, the EID include a seminar on wealth management. In what way is this an extension of institutional management techniques to private asset management?

In the framework of the chairs on new approaches to the management of lifecycle funds and the application of ALM (asset and liability management) techniques to private asset management, we have shown that private asset managers’ current practices do not take sufficiently into account their real objectives, in particular the protection over time of wealth objectives. Moreover, when asset managers try to introduce a lifecycle risk dimension, which is the starting point of any long-term financial management approach, the most widespread approach consists in focusing only on the passage of time when it comes to determining the share of risky assets in the overall portfolio allocation. This practice leads to allocations which are both sub-optimal and very risky for clients. We would have thought that the serious difficulties of individual pension funds managed in the United States and Great Britain would have led private asset managers to question the risk management of their long-term asset allocation. The inescapable fact is that this is not the case: the lifecycle approach is not seriously implemented in private asset management.

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