The investment process is framed by reference to a risk budget aligned to the investment.
A risk budget is the amount of investment risk, relative to liabilities, an investing institution wishes to take. Risk budgeting is a risk modelling tool (similar to asset liability modelling) which aims to define the risk budget and allocate it among different investments in the most efficient manner. Risk budgeting typically has a shorter outlook than asset liability modelling, and can also assess how to allocate the risk budget among different types of investment management, as well as different asset classes.
Investing institutions operate in global financial markets where the management of risk and uncertainty is crucial to the creation of long-term value. Risk-taking against well-defined objectives is an essential ingredient in any well-governed financial institution. The extent to which risk-taking is a deliberate and managed activity depends upon the governance budget allocated to this function within the institution.
The risk budget concept recognizes that asset owners are required to take risks to aim to achieve the desired return outcomes. Risk budgeting provides a quantitative framework for determining how much risk needs to be taken to achieve the return objectives, what the expected reward is for each unit of risk, and the relative attractiveness of different investment opportunities and initiatives, asset classes and managers.
Once a risk budget is defined, it will be used to formulate a strategic asset allocation (as outlined in Guideline 11, Risk budget analysis and utilization) and to formulate a dynamic asset allocation reflecting extreme market valuations (covered in Guideline 12, Dynamic investing).
- The board should monitor a risk budget model provided by the management or investment committee, consistent with explicit beliefs.
- The management or investment committee should develop and implement a defined risk framework with prioritization of risk measures, while also accepting ambiguity of “risk” interpretation and weaknesses of different risk measures.
- The management or investment committee should periodically provide the board with risk studies and reports, and recommend risk mitigation policies and measures for adoption.
- The management or investment committee should present to the board, on a recurring basis, a risk report which captures the essential elements of the risk budget model required for effective board decision-making.
- The board should decide on an aggregate risk budget that is consistent with the mission and goals.
- There should be a clear articulation of the various risks faced by the investing institution. The analysis of these risks should consider an appropriate measure or measures of risk. In addition, correlation between the different types of risk should be taken into account.
- There are a number of risks faced by the investing institution; these include, but are not limited to:
- Economic conditions risk (including inflation risk);
- Financial markets risk;
- Capital structure risk;
- Leverage risk;
- Operational risk;
- Reputational risk;
- Investment manager risk;
- Currency risk;
- Liquidity risk;
- Market risk;
- Credit risk;
- Geopolitical risk;
- Custodial risk;
- Counter-party risk;
- Concentration risk;
- Extreme risk.
- There should be acceptance of the difficulties associated with defining, measuring and managing risk.
- There should be prioritization of the various risk measures, including understanding of the potential reward associated with each risk.
- There should be acceptance of the principle that the risk budget is to be “spent” in the most efficient way to generate the maximum return outcome.
- There should be consideration of the need to balance absolute risk (versus mission) and relative risk (versus benchmarks) with the overall need to ensure that absolute measures take priority.
- The board should provide oversight that the risk is borne equitably across different generations of scheme participants and other stakeholders.