“The fundamental premise of risk management is accepting that there are inherent uncertainties in the longer-term pursuit of making money,” says Sebastian Vadakumcherry, APFC’s Chief Risk and Compliance Officer. “Understanding and appreciating how much an investor could expect to lose can lead to better investment decisions.”
Most investment institutions have a target return or benchmark goal that they are trying to achieve. To meet or exceed those goals, institutional investors need to take risks with their capital. With the understanding that the same level of return can be earned with varying levels of risk, risk management helps to achieve targeted returns with the lowest level of risk.
Every investment institution has likely seen periods – days, weeks, or years – where their portfolio has diminished in value. The objective of risk management is to be risk aware, not risk averse. Understanding potential portfolio losses based on the risks associated with the asset enables investors to prudently reposition a portfolio to minimize them.
Targeted returns and targeted risks
As an investment institution managing the assets of the Alaska Permanent Fund, APFC is in the business of taking risks. While no investor wants to lose money on an investment, it is impossible to have zero risk and achieve performance goals. Just like there are targets for investment returns, APFC also has targets, or thresholds, for risk. Compared to investment performance, it is much less intuitive to quantify risk management’s success, essentially measuring a portfolio’s ‘not lost’ value.
For the Alaska Permanent Fund’s risk metric, it was important to understand the worst-case scenarios for portfolio devaluation in pursuit of targeted returns. Using financial models and historical data, APFC was able to create a benchmark for the appropriate amount of risk necessary to achieve the Board of Trustee’s long-term return objective of inflation plus 5%. In 2021, the Board agreed to adopt a formal risk appetite in terms of a portfolio consisting of 80% stocks and 20% bonds.
A key tool of risk management is diversification, a concept we’ve heard about all our lives – don’t put all your eggs in one basket. Diversification can be within the same asset class, owning shares in multiple companies, sectors, or countries as opposed to only one, or across asset classes, owning shares, bonds, real estate, and alternative assets. Diversification has proven to be one of the most predominant and effective tools for risk management. However, diversification alone doesn’t always provide the lowest risk for a target return.
To safeguard the Permanent Fund, APFC also uses financial risk modeling. Every day, APFC’s Risk and Compliance Team ensures that the Fund complies with the Corporation’s Board-approved Investment Policy and regulatory requirements. Risk is measured and monitored daily using statistical techniques, cutting-edge technology, and innovative data platforms. Value at Risk (VaR) and Tracking Error (TE) are two key risk measures, among others, that the team computes, monitors, and reports daily. Exposures and risks are viewed across multiple dimensions, including geographies, sectors, currencies, asset classes, and derivative instruments. If exposures or risks exceed board-approved limits resulting in an anomaly, the Investment Policy defines the appropriate steps to take for compliance.
Risk management is not strictly limited to reducing risk. In fact, there have been occasions where investors may have the opportunity to take more risk or deploy more funds into a given market or strategy. The goal is not to avoid risk but instead to take the right amount to achieve the desired returns.
“As investment professionals tend to focus on achieving premium returns, and risk management professionals tend to focus on preventing mishaps, there can be a natural, healthy tension between those functions at any investment firm,” says APFC CIO Marcus Frampton. “Having a group of smart professionals, like APFC’s Risk and Compliance Team, looking at the same questions from another angle, providing portfolio analytics and collaborative elements, is always helpful in the overall management of the portfolio.”
Besides financial risks, other risks require attention, including operational, governance, IT, regulatory, legal, and reputational. APFC strives to build and maintain a culture of risk awareness, ensuring that everyone in the organization understands what could potentially go wrong and remains alert. APFC’s Risk and Compliance Team engages with all other teams across the Corporation to understand their processes and help avoid any significant mishaps.
Safeguarding the Permanent Fund
“As stewards of the Permanent Fund, APFC’s first objective is to safeguard what we already have, and the second is to ask how much more can we make by utilizing this Principal?” Says Sebastian, “I’m stating that as two separate priorities, without any ambiguity.”
Over the long horizon, APFC’s objectives of safeguarding the Permanent Fund and maximizing returns can be achieved only with prudent risk-aware investment processes. 2022 was generally a down year for investments. Public equity markets were down nearly 20%, but the Permanent Fund ended the fiscal year down just 1.32% without crossing any of its risk thresholds. This outperformance compared to the benchmark highlighted the Corporation’s prudent investment management and a strong risk-aware culture that recognized the advantages of growth opportunities while withstanding economic retractions.
Through a risk-weighted targeted-return strategy, APFC’s staff are empowered to challenge assumptions, invest more confidently, and build a stronger return environment for the benefit of all Alaskans.