After determining to employ a new way of evaluating portfolio risk which overlays risk across asset classes, rather than replacing asset classes with risk categories, CalSTRS now just has to work out how to do it. AMANDA WHITE reports.

Unfortunately life doesn’t fit into neat buckets, and neither does risk, the investment team at the $146 billion California State Teachers Retirement System (CalSTRS) have discovered. According to CIO Chris Ailman, the fund had intended to conclude its evaluation of risk management by allocating according to risk budgets. “We came up with the risk overlay approach after a meeting in early January with Martin Leibowitz from Morgan Stanley, our staff and Allan Emkin and his staff. We fully intended to come up with risk buckets, but found that the number of risk buckets depended on your time period, and over the really long-term they blend in to one or two,” Ailman says. “Everyone wants to keep the world in a spreadsheet but the world is messy, you can’t put into neat buckets.

It would be nice if risk was neat, if for example you could say a particular risk was exactly 83.6 per cent and we could hedge to that decimal, but life is complicated.” From a graphical viewpoint, tather than allocating risk according to a neat colour wheel, CalSTRS decided it was more like the mess of an artist’s palette, which Ailman describes as a “clever nuance”. “We decided that you can’t say for example 65 per cent of the portfolio is exposed to global GDP – because it affects real estate, fixed income, cash, as well as equities.” The fund has come up with six core risk factors, but instead of using them to divide the portfolio by exposure, they will be overlaid across the entire $146 billion portfolio, as well as used to dissect each new investment to understand its risks.

The six core risk factors are: • global economic growth – uniquely, CalSTRS is considering dividing the world by the average age of a country’s population rather than the traditional division of emerging and developed, to determine a measure of expected global economic activity and corporate profits; • interest rate risk; • inflation risk; • liquidity – fluid markets; • leverage/financing; and • investment governance risk. But, to some extent, deciding on what the risk exposures are is the easy part. The next step, according to Ailman, is to spend four to five months bedding them down, working out how to measure them and determine what their cycles might be. “We need to figure out how to measure these risks. And we need to determine, for example what is the strategy if we think interest rate is a high risk or global GDP is a risk. What do we do about it, and do we need more tools?” What is clear, is that CalSTRS is prepared to think of risks differently.

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