I regularly emphasize the numerous risks (and related risk management best practices) associated with investing in my speeches and articles. It's a veritable alphabet soup. However, the L risks seem to be getting a lot of attention in recent days. According to "Ray Kanner Thinks We Need To Focus on the Three L's" (ai-CIO, December 2010), this Chief Investment Officer for the $85 billion IBM defined benefit plan calls out three in particular - liabilities, leverage and liquidity. His advice to others is to look at the risk and complexity of overlay strategies while focusing on "what percentage of liabilities should be hedged, and how to get there."
As I wrote in "Leverage - I Love You, I Need You - Don't Hurt Me," derivatives (as one of several ways to manufacture leverage) can be used to hedge. They can likewise serve to turbo charge portfolio returns if the markets move in the right direction. However, when yield enhancing strategies result in "excessive" risk-taking, leverage can worsen an already bad problem in terms of losses, cash outlays, transaction costs and asset allocation strategy revisions.
Leverage and liquidity are not the only L risk factors to consider. For defined benefit plans around the world, longevity, literacy, loss and litigation should not be ignored. Read more about The Six Ls in "Are Your Pension Clients Up to the Challenge?" by Dr. Susan Mangiero, CFA, FRM and written with attorneys in mind.
Each of these important issues has its own set of consequences if left unattended. Moreover, the risks are often interrelated. For example, an institutional investor may deploy monies to a fund manager that is using over-the-counter derivatives to add leverage, in anticipation of a greater payoff than what might be possible otherwise. If a flight to quality occurs for whatever reason(s), the pricing of the derivatives could move quickly and sharply in the wrong direction and force margin calls. Jittery investors may submit an unusual amount of redemption requests which then puts pressure on the portfolio manager to try to liquidate his or her holdings at the worst time. Valuation issues are always a challenge with less liquid instruments and reflects its own set of risks.
This is not to say that leverage is good or bad or that pension plans should steer clear of less liquid investments. It's only to reiterate that risks exist and investors and their advisors must do a thorough job of vetting various asset managers and strategies to feel confident in their decisions and subsequent oversight.
More to come in other posts about longevity, litigation and the array of L risks.