Annual Report Risk

Risk rules.

Statement from
Jagdeep Singh Bachher
Chief Investment Officer
and Vice President of Investments
Jagdeep Singh Bachher

Three years ago, we set out to answer a question: How can our products best fulfill their mandate? Working together as a team, we pored over the literature and picked the brains of recognized investment leaders and like-minded peers. The result was a set of 10 principles — or, as we like to call them, pillars — that guide us day in and day out.

Given the nature of what’s going on in the world economy, one of these pillars, Risk Rules, has been a particular focus for us. Here’s why: though standard risk tools are crucial in helping us understand complex and nuanced investments, they won’t guide us through the next market crash.

So I set out to bring in someone with deep experience and vision, someone who understood we needed to manage risk, not just measure it. We found that person in Rick Bookstaber, who joined our team as chief risk officer two years ago. Together, we’ve worked to shift our culture to one that takes a more innovative approach to risk. Today, risk management isn’t just a function or a department. Everyone on our team is now a risk manager.

We’ve also developed new, forward-looking risk management systems and formed valuable partnerships so we can better predict how an event will affect our products and our returns.

Using our new risk management approach, we’re making every investment decision with our eyes wide open to its risk now — and in the future.

The 10 pillars of
centennial investing.

1
Less is more.

“You have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.”
–Steve Jobs

We believe in high-performance teams working collaboratively to manage a concentrated portfolio of high-quality assets. That’s why we are working actively to reduce the number of decisions we have to make, the number of line items in our portfolio and the number of external managers we use. The result is an agile, world-class team with a laser focus on the areas where we can outperform the market.

2
Risk rules.

“In investing, what is comfortable is rarely profitable.”
–Robert Arnott

We are working to shift the culture of UC Investments so that everyone on our team becomes a risk manager. We’re also allocating our assets according to the risk factors that drive returns to create more diversity and generate more return per unit of risk. Formalizing our expectations around risk will enable us to assess a single portfolio while also respecting the changing nature of each of our product lines’ risks.

3
Concentrate.

“Wide diversification is only required when investors do not understand what they are doing.”
–Warren Buffet

We are working to construct portfolios from a concentrated set of assets that we understand deeply, as opposed to holding many assets that we barely understand, that cost us more to manage and that are passively replicable. By reducing the number of investments in our portfolios, we believe we can reduce unwanted risks and increase desired returns, while balancing the need to be proactive with the need to adhere to the diligence requirements of our organization.

4
Creativity pays.

“The person who goes farthest is generally the one who is willing to do and dare. The sure-thing boat never gets far from shore.”
–Dale Carnegie

We are focused on developing competitive portfolios, even if, at times, that means taking an unconventional or uncomfortable stance. One way we are building a culture of innovation is by developing a dedicated innovation team in our organization — a rarity in the world of institutional investment — to incubate, validate and develop creative vehicles that leverage our competitive advantages.

5
Build knowledge.

“An investment in knowledge pays the best interest.”
–Benjamin Franklin

We consider ourselves remarkably lucky to be sitting at the heart of such a knowledge-rich university environment, and we are working to get the right systems, policies and processes in place to capitalize on it. We are putting an emphasis on building a culture of collaboration to break down silos and share information across the organization. We are also investing in high-quality data infrastructure to track portfolios, risks and networks.

6
Team up.

“Talent wins games, but teamwork and intelligence wins championships.”
–Michael Jordan

We realize that to be successful, we must attract the highest-caliber people who are in alignment with our culture and our long-term approach to investing. We target our recruiting where we are most likely to be successful. The gray: those who’ve had successful careers in the private sector and want a change. The green: bright young recruits who want to accelerate their careers. The grounded: loyal UC alums and others who want to live in California.

7
What makes UC, UC.

“If you don’t have a competitive advantage, don’t compete.”
–Jack Welch

As the investment organization for one of the premier public research institutions in the world, we have an abundance of characteristics that, if cultivated appropriately, should be a persistent source of high-quality investment opportunities. Our innovation ecosystem is unparalleled on a global scale, and because we sit at the center of it, we believe we can leverage our unique characteristics in ways that drive investment returns.

8
Perfect alignment.

“Control your expenses better than your competition. This is where you can always find the competitive advantage.”
–Sam Walton

Now more than ever, we need to fully understand what we’re paying for. If a third-party manager isn’t willing to provide a detailed breakdown of how they make their money from managing our money, then we should be willing to pull our capital and walk away. By having complete transparency and a better understanding of our investment risks, we will reduce misalignment of interests and capture risk-free returns.

9
Man meets machine.

“You are cruising along, and then technology changes. You have to adapt.”
–Marc Andreessen

Sitting on our perch here in Silicon Valley, we believe we can use technology to help us streamline and strengthen operations to level the playing field between us and the private financial-services industry. In the years ahead, we’ll be working with innovative startups to better understand and manage our portfolios and gain greater access to unique markets that had previously been too expensive for us to enter.

10
Centennial performance.

“We should all be concerned about the future because we have to spend the rest of our lives there.”
–Charles Franklin Kettering

We think of ourselves as an organization that invests for the next 100 years. Our centennial orientation drives us to assess our portfolio in ways that consider the long-term, fundamental challenges facing society like climate change, human rights or corporate governance. We’re also working to incorporate a broader set of risks into our decision-making than organizations with shorter time horizons.

Q&A with
Richard Bookstaber

Q&A with
Richard Bookstaber
Chief Risk Officer,
UC Investments
Richard Bookstaber

How is risk management different here at UC as an asset owner than in the private sector, like banks and hedge funds, and in the regulatory arena?

For a bank or a hedge fund things can change from day to day. There is a lot of trading and a lot of leverage, so things can go south quickly, and often you can’t get out of the way of a problem fast enough. In terms of the management of systemic risk at the regulatory level, it really is a different animal because you might see what is happening, but the political constraints make it difficult to take action. The asset owner world is in some sense the sweet spot for risk management because you have time to see what is coming and you also have the ability to make adjustments before it hits.

Your latest book, The End of Theory, builds off things you learned about risk from the 1987 crash, the Long-Term Capital Management hedge fund and, of course, the aftermath of 2008 crisis. Are there general lessons in these for how we fail in responding to crises?

It’s hard to find general rules, but I can think of two things. First is missing the implication of changes in the world. There were new strategies — portfolio insurance in 1987 and new types of financial instruments coming into 2008 — yet people were using the same standard risk systems and methods.

Also, sometimes it’s just that things slip. If something is coming from a new direction, even if you have the analysis and it’s staring you in the face, it just doesn’t catch anyone’s attention. Really, that happens. Or, it’s noticed but no one takes action; analysis paralysis. Talking about the problem meeting after meeting but no one owning it and pulling the trigger.

Is it a matter of inertia? Or not wanting to rock the boat?

It’s partly because of inertia. It’s also partly because of a lack of courage, because taking action means reducing exposure and that means lower returns if the risk doesn’t end up realized, which happens more often than not. But mostly I would chalk up the failure to act to wishful thinking. It’s like people just can’t believe something is wrong — or that it can get any worse — because they have no past experience with it. It could be that their own experience is limited or maybe the sort of dynamic has never occurred before.

Would you say this is just the way people are — wishful thinkers who go with the flow?

Well, maybe; but then I guess that is one reason not everyone should be a risk manager! But really, this is a natural result when quants [quantitative analysts] are sitting in cubicles running their models and just throwing numbers over the wall. They are doing the risk analysis, but the decision makers don’t own it; there isn’t top-level support. And you actually need more than support; they have to be in the process because each crisis is new and coming from different areas.

You’ve developed a new approach to looking at risk: agent-based models. How does the agent-based model approach address the problems you’ve just discussed?

During market dislocations and times of crisis, there are so many moving parts, with all sorts of markets and institutions interacting. Yet the fact of the matter is that our standard approaches can’t deal with crises because they do not build in how a market shock might affect the actions of one institution — for example a hedge fund having a margin call and being forced to liquidate — and how that might in turn affect another institution — maybe a bank or dealer who then stops making markets to preserve its capital. I believe agent-based models can deal with these interactions and their resulting changes in the market environment. Agent-based modeling tries to analyze what each agent — banks, hedge funds, pension and endowment funds — will do as a situation develops and worsens, and thus how the crisis will propagate.

But aren’t you still in the realm of the quants throwing the results of a different model over the cubicle?

The key is that the model has to be part of the risk discussion. People still need to sit around the table and think things through, basically work through different stories and plot lines for how a risk might propagate. And you can do that with an agent-based model because it’s not a jumble of equations; it follows the story of how each market and each agent, that is, each institution, is acting as the crisis runs its course. This is what people do all the time when it comes to investments, but not so much when it comes to risk. However, they really are two sides of the same coin.

How is UC Investments using agent-based modeling to manage its risk?

The path to integrating this approach at UC, which we call Risk Management Version 3.0, has been first to build the model, and then to pull together the data to run it. Getting the data is as difficult a task as the model itself. We need to know things like where leverage is lurking in the market, where there is crowding in strategies, and other things that you can’t just pull up on a Bloomberg machine. Then we need to huddle with our partners to determine what scenarios are of the greatest concern. We are not to the point of being able to push a button and get a full-body scan; we need to point the model on a particular target.

The end result is a Version 3.0 Risk Report that shows where our portfolio will be sitting as a particular crisis washes its way through the markets. We are having discussions all the way through this process — from defining the agents of the model, to pulling together the critical data on leverage, illiquidity and concentration, to building and running the scenarios — so it gets integrated into our risk-management thinking.

We are all
risk managers.

Risk is at the core of the UC Investments process, one that starts with the Regents setting our risk tolerance to achieve the objectives for the respective products and stakeholders. We use an integrated approach to risk management and have worked to create a common culture to support that approach: we have common ownership of our portfolio risks, and we all share responsibility for the entire portfolio.

Rather than focus on filling asset buckets based on asset allocation targets, we aim to seize opportunities however they arise, with the best asset class to execute on that opportunity. This puts more demands on risk management and requires input and support across our entire investment team, from the Regents to the CIO to the product teams.

How we
measure risk.

At UC Investments, we apply three levels of quantitative risk measurement to our decision making — Risk 1.0, 2.0 and 3.0 — with each level building on, not eliminating, the previous one’s value.

Risk 1.0:
The Future as History

This is the standard risk management approach that’s been used for over two decades. Here, the returns of the current portfolio are evaluated by looking back at history and trying to answer these questions: If the current portfolio had been held over the past, how much would its returns have varied? How volatile would it have been?

Looking at the past two years of our products as a guide to evaluating the future risk, we find our General Endowment Pool (GEP) has an annualized volatility of 7.2% and UC Retirement Plan (UCRP) has an annualized volatility of 7.5%. Putting this in intuitive terms, we should not be too surprised if, over the course of a year, we find returns vary by seven percent or so. In more technical terms, the 7.2% is the one standard deviation range for returns, and we can expect returns to vary within that range with about a 70% probability.

To add some context, applying this risk level to a portfolio holding only the S&P 500 gives a volatility of 10%. So both GEP and UCRP are about three-fourths as volatile as holding the S&P 500 index.

But the recent past has not been typical. Over a longer time period, the S&P 500 has been more in the 15- to 20-percent range, and our portfolios have tracked closer to 10%, so still about three-fourths the risk of holding the S&P 500, but higher risk in absolute terms.

We’ll discuss more about the implications of our current low-volatility regimes later in this report, but the important point here is that low volatility now can set the stage for higher risk down the road.

Risk 2.0:
What if?

After the 2008 crisis, it became apparent that Risk 1.0 failed because the risks in the crisis did not look like those of the past. So a new way to look at risk arose, Risk 2.0: stress and scenario analysis.

With stress analysis, we are not wedded to historical asset performance as the guide. Instead, we hypothesize about the effect of various scenarios, each of which could include a variety of events and market stresses. Three illustrative scenarios we are considering in the current environment are:

  • Stresses in specific markets
    “What will happen to our portfolios if stocks drop by 10 percent?”
  • Multi-faceted scenarios
    “What will happen to our portfolios if China has a credit crunch, with all of the market dislocations that this would imply?”
  • Stresses in history, Risk 1.0-style
    “What would happen to our portfolios if the 2013 “Taper Tantrum” were to occur again?”

Since we don’t know what crises are on the horizon, we stress test our portfolios by applying two market shocks: a 10% drop in the S&P 500 Index and a 100-basis point rise in the U.S. 10-year Treasury Bond. Each of the hypothetical scenarios combines shocks to a variety of markets and is based on how these various markets would likely become embroiled in the event. So capturing the risk for these two stressors is more than simply a matter of taking our exposure to the S&P 500 and the U.S. Treasury, respectively, and multiplying these exposures by the shock we are hypothesizing.

Our public equity positions drop essentially one-to-one with the shock to the S&P 500. For the Treasury shock, we lose 3.4% in our fixed income positions because when rates rise, bond prices drop. However, we more than make up for that loss through the effect of the rate increase on our equities.

We are exposed to the three scenarios we consider here, most notably to an increase in market volatility and a Chinese credit crunch, which will lead to a drop in our equity positions in the 8% to 9% range. A repeat of the 2013 “Taper Tantrum” shock hits both our equity and fixed income positions. A large Federal Reserve balance sheet unwind could spark a similar episode.

Risk 3.0:
What Happens Next?

Though Risk 2.0 gives us more risk guidance than 1.0, it still doesn’t get us where we want to be. The issue, as we all know from the financial crisis of 2008, is that one problem leads to the next, with cascading — and sometimes snowballing — dynamics that can embroil the market. The initial shock is never the end of the story.

And the plot of the story is often intricate and unpredictable. For example, a market drop will force those who are leveraged to sell. Their selling pushes prices down further. They can’t sell in a market that is under pressure, so they start to sell other assets in their portfolio, which creates contagion. With the prices dropping and volatility increasing, potential buyers pull back and funding dries up. The result can be a “fat tail” risk, a risk that emerges down the road from the initial shock as these various dynamics gather speed. History-based Risk 1.0 cannot pick up on these dynamics. They occur infrequently, and each time they are different. So the standard 1.0 depiction of risk is that it grows symmetrically and smoothly over time.

So to really deal with risk, we have to capture and understand this dynamic, which is what Risk 3.0 is built to do. The foundation of Risk 3.0 is a method called Agent-based modeling. This approach seeks to capture the dynamic evolution of financial market contagion. Agent-based models have been used for years in other fields, to understand the emergence of traffic congestion on the roadway, for example, or of panics and stampedes during fires. If it sounds like this type of modeling should carry through to the essence of crisis behavior in the financial sector, you’re right. And by comparing the implications of following through with the dynamics of various market stresses with the shock test results from Risk 2.0, we get a more complete picture of what we’re facing and how we can best react.

We are on the leading edge of Risk 3.0 in the industry, developing the models and data sources needed to manage our risk in this revolutionary way. This involves crowdsourcing data and surveying the various financial market agents to understand the leverage, liquidity and concentration that each of these agents hold and the rippling effects they may cause. Though we still are in what might be called the Beta version of Risk 3.0, we believe it will allow us to steel ourselves against the next crisis. Or maybe even profit from it.

Risk 3.0 Case Study:
A low-volatility environment

Volatility is currently at or near its lowest levels in over 20 years for many asset classes. Paradoxically, a sustained period of low volatility breeds increasing risk because life seems easy; investors are more willing to take on leverage, market makers are more ready to provide liquidity and funding is easier to come by. Complacency comes into question.

If we look at our exposure to a rise in volatility through the simplest lens, that of Risk 1.0, it appears risk is minimal. We don’t have option exposure, so a mechanical calculation of the change in the value of our positions with a change in volatility will come out to be close to zero.

But when we go to Risk 2.0 and take into account the broader scenario of asset markets that tend to be affected by a rise in volatility, we find our exposure is not insignificant. Extending the Risk 2.0 scenario beyond public equities and fixed income to include our other asset classes — using both BlackRock and internal methodologies — we calculate a loss from a sudden 20% rise in equity volatility as measured by the index to be 5.8% in GEP and 6.1% in UCRP.

That, however, would not be the end of the story. If we move to Risk 3.0, we consider the cascades and contagion that will come from the dynamics and feedback. For example, those with high leverage and those who are targeting a predetermined level of volatility would be forced to trim their portfolios, and those invested in volatility-related Exchange-Traded Funds (ETFs) would react to large declines in the value of these instruments. We would expect after these rippling effects for losses to be larger than they would appear if we stopped with Risk 1.0 or 2.0.

Managing risk
the UC way.

Culture: Speaking the Same Language

An essential part of risk management is having a common, shared view of risks and working together to find common risks wherever they may lurk within the portfolio. For example, there will be equity risk in both public equities and real assets; there will be inflation risk in fixed income, but also in real estate.

In order to understand the components of risk that thread across the various asset classes, we augment the standard, asset-based risk approach with one using risk factors. We use macroeconomic factors that look at the essential components of risk that are endemic to the financial landscape: economic growth, real rates, inflation, credit, emerging markets, commodities and foreign exchange. We then determine the exposure of each asset class to these factors and sum across the exposure to get a measure of our overall portfolio factor risk.

What is remarkable, but actually not unexpected, is that economic growth is the dominant factor for both GEP and UCRP, as it is for most other pensions and endowments; it makes up 79% of our risk for GEP and 85% for UCRP. Economic growth is the naturally dominating factor for equities, but is also prominent in everything from real estate and real assets to private equity, reaching into all of the asset classes.

Of course, not all of our risk is explained by the factors mentioned above, or for that matter, any other set of factors. The “residual” indicates the risks that remain unexplained and will include asset-specific, idiosyncratic risks.

Process: From teams to product managers and back

The process that takes us from measuring risk to managing risk involves all of the teams at UC Investments. We verify the data used for risk measurement, assess the reasonableness of the resulting reported risk, and then start the iterative process. We start with the desks that oversee the various asset classes and then involve the product managers who have front-line responsibility for integrating performance and risk for GEP, UCRP and Working Capital and need to look at these in tandem.

A member of our risk team works with each desk to certify that the position data coming into the risk system is correct. Once the risk reports are generated, the results are reviewed with the desks to make sure everyone is on the same page. Because the markets are dynamic with new strategies, events and instruments, the review is also an opportunity to uncover other dimensions of risk that need to be monitored.

Once the final risk report is generated, it is reviewed by the product managers and we have further discussion of new and emerging risks before the report is finalized and presented to the CIO.

Integration: Opportunity & Risk

The twin edges of the sword for investment decisions are opportunity and risk, or the expected returns and the volatility of returns. Once the risk is verified and shared, the task is to tie it to these decisions.

Often risk management is treated as an add-on to investments, sometimes even as a control function akin to accounting and audit. In that role, the risk team throws the risk numbers over the cubicle, and they land on the portfolio managers’ desks without any context.

At UC, we believe the key to effective risk management is to overcome this tendency and have all of our investment professionals share the same understanding of risk. Each team member looks at risk in the context of our total portfolio, rather than only their own, and then integrates risk into the investment discussion.

It’s a robust process. Back-and-forth with the desks and product managers. On-the-ground views of the markets that inform us of emerging risks. Assessing the position integrity going into the risk reports and risk measures coming out as well as the use of common factors that thread risk exposures across all of the positions.

The bottom line: We can play better defense by trimming exposure to the markets that will be affected, perhaps only secondarily as collateral damage. And we can move to a posture of greater liquidity, not only as a defensive posture, but to keep powder dry to enter the market opportunistically as a dislocation runs its course.

All of this is in service of one goal: Making sure we’re in alignment with one of our key investment beliefs and pillars: Everyone is a risk manager. Risk rules.