Matthew Leatherman on managing risks across time horizons and approaches to climate change
Head of Programs
Institutional investors are challenged with risks and priorities across time horizons. Meanwhile climate change is impacting on how investors approach their investments and risks. Institutional Connect recently interviews Matt Leatherman, FCLTGlobal’s Head of Programs and co-author of Balancing Act: Managing Investment Risk across Multiple Time Horizons, who provides comments on how to manage risks and achieve climate change goals.
Institutional Connect: Institutional investors are challenged with managing risks across multiple time horizons. The impact that an event such as COVID brings to portfolios can be significant. How should institutions balance their strategies between long-term horizon and short-term market volatility?
Matt: A paradox of long-term investing is that, all else equal, the longer the horizon, the more concern an investor has to show for what happens along the way. Part of the reason is statistical, and part is behavioral. Statistics point out an inescapable fact: the longer that an investor holds a position – or a portfolio, or an asset allocation – the greater the chance of encountering a drawdown and the larger that drawdown can be. Risk professionals can quantify these risks with statistics like within-horizon value-at-risk, and long-term risk professionals do so. The reason is behavioral, at least in part. Setting realistic expectations at the start of an investment period can lessen surprise when risk materializes, frame whether the risk is within or outside the bounds of the investment strategy, and increase resolve to maintain the strategy if the risk is within bounds and likely to be transient. It may be that risk professionals themselves already have an intuition about what to expect, but the job of long-term risk professionals includes setting the same expectations for trustee directors, executives, and portfolio managers because their behavior influences the institution’s, namely whether or not the institution perseveres through environments like short-term volatility.
Investors with long holding periods will have their focus and resolve tested, and knowing in advance the tests that are likely to come can ready them for success. Information about interim periods is the source of that knowledge.
Of course, investment risks vary widely. Covid, for instance, is very different from a regular market correction. It’s important to have multiple perspectives on risk precisely because the types of risk vary so widely. Models of fragility and turbulence may be needed for a disruption like covid, in which risk converges massively, while models drawn more from normality can suffice for navigating the ordinary noise of the investment world. Having these multiple perspectives can produce different information and also different governance conversations.
Institutional Connect: How is climate change impacting on the ways that institutional investors approach their risk strategies?
Matt: The methods that institutional investors use to manage risk depend on statistical assumptions and inputs pioneered in the 1950s. They have evolved since then significantly, but that was the last revolution. Putting climate commitments into real investment practice could be the next revolution.
There are at least two revolutionary aspects of climate change for the risk profession. First, it introduces long-term trending patterns into asset prices and challenges the assumption of mean reversion. As a result, risk professionals in long-term institutions will have to fundamentally rethink the statistical distributions that they use for computing probabilities. Second, there is no historic data on climate change with which investors can reliably and precisely extrapolate this distribution.
One specialist in climate research has put this best: “We have about twenty-plus years of this changing climate, not a hundred, and the next fifty to a hundred are going to be far different than the last hundred… what I recommend is that we use forward-looking projections essentially for the first time in our industry without a back history to prove them. The back history of proof is that the science has been accurate.”
The implications will reshape the profession of risk management within long-term investment institutions. As a colleague and I wrote in a recent opinion editorial, “risk managers will have to shoulder the responsibilities of discretion that portfolio managers already carry. Specifically, they will have to choose time horizons deserving of focus, specifications about the distributions to use, performance controls for interim periods, and management techniques to invoke when markets become turbulent.”
Institutional Connect: An increasing number of institutional investors have established climate change goals for their respective portfolios. What approaches can investors take in achieving their targets?
Matt: When an institutional investor makes a Net Zero 2050 or other sort of climate commitment, that institution is accepting an additional responsibility for how it earns its return. Fulfilling responsibilities like this involve questioning central aspects of how the institution does it’s work, including the investment strategies that it uses, metrics for staff, risk management techniques, time horizons, and performance outcomes.
Translating a commitment like having no carbon emissions by 2050, on net, into standing investment practices is difficult. Institutional investors have to decide how to get started and how to judge whether they are on the right path, for instance, in a highly uncertain environment. Ariel Babcock, FCLTGlobal’s Head of Research, and a colleague wrote earlier this year about how investors’ approaches have evolved from myopia, or “overly discounting the potential for future investment losses from climate change,” toward being a catalyst for mitigation and adaptation through the allocation and engagement choices that they make.
Institutions that approach this challenge proactively, as a catalyst for mitigation and adaptation, can begin by doing the internal work of updating their investment beliefs and risk appetite statement, expanding their benchmarks to include science-based targets that match their climate commitments, and renegotiating investment mandate contracts to include climate responsibilities within their scope. In these senses, making a climate commitment really just adds a dimension to designing a long-term portfolio more generally.
Institutional Connect: How should institutional investors navigate through lack of standardization of data while incorporating responsible investing mandates into their portfolios?
Matt: Institutional investors, including those with long horizons, grapple with the challenge of data validity, reliability, and significance in very different ways. One camp has the strict investment belief that what gets measured, gets managed. Another has a firm investment belief that not everything that counts can be counted. And many institutions sit at various places between these two end points.
Long-term investors nonetheless seem to share at least two understandings.
The first is that uncertainty increases with time. It is harder to estimate the future the further out that you try. Accordingly, some degree of uncertainty is inherent for long-term investors. Perfection is not the standard, and having management techniques for navigating uncertainty is important.
The second is that we can do better with data validity and reliability than we are now. Giving up is not an option. Rather, long-term investors are hard at work through the Value Reporting Foundation’s advisory bodies and networks, for instance, to improve this data.
Long-term institutions will navigate in a variety of ways within these boundaries based on their particular investment beliefs. This can be a familiar position for them, given their understanding of how important investment beliefs are for long-term focus and their appreciation for how these beliefs can differ for many reasons, including different purposes, time horizons, and strategies.