The Need for Investment Solutions
The investment industry is currently experiencing profound structural changes, in the face of new challenges that are faced by both institutional and individual investors. For pension funds in particular, the shift in most accounting standards towards the valuation of pension liabilities at market rates (mark-to-market), instead of fixed discount rates, has resulted in an increase in liability portfolio volatility. This new constraint has been reinforced in parallel by stricter solvency requirements that followed the 2000-2003 pension fund crisis, and ever stricter solvency requirements are also increasingly being imposed on insurance companies in the US, Europe and Asia.
These evolutions in accounting and prudential regulations have subsequently led a large number of corporations to close their definedbenefit pension schemes so as to reduce the impact of pension liability risk on their balance sheet and income statement. Overall, a massive shift from defined-benefit to defined-contribution pension schemes is taking place across the world. As a result, individuals are becoming increasingly responsible for making investment decisions related to their retirement financing needs, investment decisions for which they have no expertise. In this context, the investment management industry has a great responsibility in terms of the need to provide individuals with suitable retirement solutions.
In the new highly challenging environment, and given the intrinsic difficulty of delivering added value through security selection decisions alone, the relevance of the old paradigm has been questioned with heightened intensity, and a new paradigm is starting to emerge, with substantial welfare improvements expected for asset owners. This paradigm has been labelled liability-driven investing (LDI) for institutional investors, whose problems are broadly summarised in terms of their liabilities, and it has been labelled goal-based investing (GBI) for individual investors, whose problems can be fully characterised in terms of their specific consumption of bequest goals throughout their lifetime.
A variety of common meaningful goals can be identified for most individuals including wealth accumulation, financing children’s education, or generating minimum and target levels of replacement income in retirement, already mentioned as arguably the greatest challenge for most individuals. Some changes with respect to existing investment practices are needed to help meet these formidable challenges. Just as in institutional money management, the need to design an asset allocation solution that is a function of the kinds of particular risks to which the investor is exposed, or needs to be exposed to meet liabilities or to fulfil goals, as opposed to purely focusing on the risks impacting the market as a whole, makes standard approaches (which are based on balanced portfolios invested in a mixture of asset class portfolios actively and passively managed against market benchmarks) mostly inadequate.
The emergence of this novel LDI/ GBI paradigm is not only a threat for traditional asset management firms, but also a source of opportunity. At the asset allocation level, we have seen that the “death of policy portfolios” has led to the development of fiduciary management services based on dynamic liability-driven investing. At the asset class level, the disappointment over expensive active multi-manager structures and over poor performance of passively managed portfolios has led to the development of factor investing based on smart beta and risk allocation. Even greater opportunities exist in individual money management, an industry which is about to experience an industrial revolution based on cost-efficient goal-based investment solutions.
In this context, the investment industry is currently experiencing a true industrial revolution that will eventually lead to scalable, cost-efficient, investor-centric, investment solutions. The design of meaningful investment solutions for individual investors is intimately related to the capacity to deliver proper risk management. The quintessence of the art and science of investment management is essentially about finding optimal ways to spend risk budgets that investors are reluctantly willing to set, with a focus on allowing the greatest possible access to performance potential while respecting such risk budgets. Risk hedging (required for securing investors’ essential goals), risk diversification (required for efficiently harvesting risk premia) and risk insurance (required for delivering upside performance needed to enhance the probability of achieving investors’ aspirational goals while securing their essential goals) are known to be three useful approaches to achieve optimal spending of investors’ limited risk and dollar budgets. While each of these sources of value added is already used to some extent in different contexts, a comprehensive integration of all these elements within a fully disciplined investment management framework is perhaps the most important challenge that our industry is currently facing. Risk management is often mistaken for risk measurement. This is a problem since the ability to measure risk properly is at best a necessary but not sufficient condition to ensure proper risk management. Another misconception is that risk management is about risk reduction. In fact, it is at least as much about return enhancement as it is about risk reduction. Indeed, risk management is about maximising the probability of achieving investors’ long-term objectives while respecting the short-term constraints they face.
In the end, a failure to properly integrate the three forms of risk management in a holistic investment framework inevitably leads to under-spending investors’ risk budgets in normal market conditions (with a high opportunity cost), and over-spending their risk budgets in extreme market conditions. This idea was intuitively discussed in Bernstein (1996): “The word risk derives from the Latin risicare, which means to dare. In this sense, risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about.“
Six Research Programmes
EDHEC-Risk Institute's six research programmes explore interrelated aspects of asset allocation and risk management to advance the frontiers of knowledge and foster industry innovation. These programmes correspond to a long-term investment on the part of the Institute. They are designed with the support of EDHEC-Risk Institute’s International Advisory Board. They host research chairs and strategic research projects that are supported by the industry.
- Asset Allocation and Alternative Diversification
The research carried out focuses on the benefits, risks, and integration methods of the alternative classes in asset allocation and makes significant contributions to the field of multi-style/multi-class portfolio construction. In particular, EDHEC-Risk research has advanced non-parametric risk estimation methods and extended the Bayesian approach to portfolio construction in the presence of preferences about higher moments of return distributions.
The programme includes the “Advanced Modelling for Alternative Investments” research chair, in partnership with Société Générale Prime Services (Newedge), the “Investment and Governance Characteristics of Infrastructure Debt Investments” research chair, in partnership with Natixis, and the “Infrastructure Equity Investment Management and Benchmarking” research chair, in partnership with Meridiam Infrastructure and Campbell Lutyens. This programme has also benefitted as part of strategic research projects from the support of CME Group on “Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation”, of Aberdeen Property Investors on the EDHEC European Real Estate Investment and Risk Management Survey, and on “Financial Engineering and Global Alternative Portfolios for Institutional Investors” of Morgan Stanley Investment Management.
- Performance and Risk Reporting
This programme aims to adapt the portfolio performance and style analysis models and methods to tactical allocation and to new forms of investments. Research looks at performance evaluation in traditional classes–investigating socially responsible investing or analysing rating methods for long-only funds–and at performance evaluation in the hedge fund universe (implementing dynamic factor models).
The programme has led to a business partnership with SIX Telekurs and to the offering of the EuroPerformance-EDHEC style ratings, a service measuring the quality of active management in the European fund management industry. This programme also benefits from the contribution of new research launched in 2013 in the area of risk reporting as part of the new research chair, “New Frontiers in Risk Assessment and Performance Reporting”, supported by CACEIS.
- Indices and Benchmarking
This programme involves three aspects of research into indices and benchmarks in traditional and alternative investment. The first aspect revisits modern portfolio theory to develop innovative approaches to constructing new forms of indices in the traditional and alternative universes. As such, EDHEC-Risk has proposed a proprietary method of style index construction for the alternative universe and launched the first composite hedge fund strategy indices in 2003.
As part of its policy of transferring know-how to the industry, EDHEC-Risk Institute has set up ERI Scientific Beta. ERI Scientific Beta is an original initiative which aims to favour the adoption of the latest advances in smart beta design and implementation by the whole investment industry. Its academic origin provides the foundation for its strategy: offer, in the best economic conditions possible, the smart beta solutions that are most proven scientifically with full transparency of both the methods and the associated risks.
The second aspect of this research programme examines the use of index products in the core-satellite approach to investment management. This programme includes the “ETF and Passive Investment Strategies” research chair, in partnership with Amundi ETF, Indexing & Smart Beta, and the “Active Allocation to Smart Factor Indices” research chair, in partnership with Rothschild & Cie. The final research dimension of this programme relates to the appreciation of the governance and transparency of indices. On the basis of its investigations, EDHEC-Risk Institute has contributed significantly to the recent consultations on benchmarks conducted by ESMA, IOSCO and the European Commission.
- ALM and Asset Allocation Solutions
This programme concentrates on the application of recent research in asset allocation for institutional, high net worth, and retail investors. The Institute is working on the idea that improving asset management and strategic allocation techniques has a positive impact on the performance of ALM programmes. It devotes particular attention to the institutional context of ALM and to the impact of International Financial Reporting Standards and the Solvency II directive project on European pension funds and insurance companies. It also aims to extend the realm of ALM approaches to address the particular needs, constraints and objectives of sovereign wealth funds, the private banking clientele, and mass-affluent investors.
In 2014, EDHEC-Risk Institute and Merrill Lynch Wealth Management launched an important research initiative on goal-based investing, which is, in EDHEC-Risk Institute’s view, a veritable revolution for wealth management. This initiative, “Risk Allocation and Goals-Based Wealth Management”, allows EDHEC-Risk Institute to be at the cutting edge of implementation of asset allocation techniques not only for institutional investors, but also for individual investors. The “ALM and Asset Allocation Solutions” programme includes the “Risk Allocation Solutions” research chair, in partnership with Lyxor Asset Management and has also benefitted from the support of AXA Investment Managers as part of the “Regulation and Institutional Investment” research chair, BNP Paribas Investment Partners as part of the “Asset Liability Management and Institutional Investment Management” research chair, Deutsche Bank as part of the “Asset- Liability Management Techniques for Sovereign Wealth Fund Management” research chair, and Ontario Teachers’ Pension Plan as part of the ”Advanced Investment Solutions for Liability Hedging for Inflation Risk” research chair.
- Asset Allocation and Derivative Instruments
This research programme focuses on the use of derivative instruments for portfolio management and on dynamic asset allocation methods in asset management and asset-liability management. Key themes include the optimal design of structured products, the role of structured products and derivatives in asset allocation, “passive” replication of “active” hedge fund indices through portfolios of derivatives, and structured products and derivatives on underlying instruments that are illiquid or lack liquidity.
This programme benefitted from the support of the French Banking Federation as part of the “Structured Products and Derivatives Instruments” research chair, and includes the research projects on “The Benefits of Volatility Derivatives in Equity Portfolio Management”, in partnership with Eurex, and “The Benefits of Dynamic Asset Allocation Through Buy-and-Hold Investment in Derivatives”, in partnership with Société Générale Corporate & Investment Banking.
- Non-Financial Risks, Regulation and Innovations
The financial crisis has been synonymous with a transfer of a portion of investor risk towards the providers of investment and related services. The difficulties that third-party fund management has experienced in the areas of asset security, pricing and compliance with regulation, suggest that this shift in the responsibilities of those involved in fund management will have a significant impact on the profit and loss accounts not only of the fund management firms but also of all the service providers who are associated with them. Against this backdrop, this research programme aims to identify the nonfinancial risks parties within the fund management industry bear as a result of their practices and of regulations, assess the importance of these risks and their impact on the parties’ solvency and business models, and propose means of mitigating these risks.
The programme benefitted from the support of CACEIS as part of the “Risk and Regulation in the European Fund Management Industry” research chair. In 2012, this research led EDHEC-Risk Institute to make important proposals for the development of mutual fund regulation in Europe, notably with the idea of restricted UCITS enabling investors to be able to identify UCITS that present very limited non-financial risk. As part of the renewal of its support to the French research teams, the French Banking Federation decided in 2013 to support the “Innovations and Regulations in Investment Banking” research chair proposed by EDHEC-Risk Institute, the issues of which are part of this research programme.