Managing risks in a world of uncertainty

CDPQ I During the Global West Government Funds Roundtable, you and three other global experts discussed the effects of non-financial risks on investing. You were asked how institutional investors should adapt to major geopolitical changes and how they should position their portfolio in this context of uncertainty. What consensuses were reached?

Claude Bergeron I We agreed not to refer to geopolitical risks as non-financial. As Ian Bremmer (President of Eurasia Group) said in Davos in January 2017, we are entering a period of geopolitical recession, with a risk of political volatility that hasn’t been seen since the Second World War. Nothing is unthinkable anymore. We could witness the dissolution of governments and military conflicts. International organizations that once played important roles could disappear altogether. These events directly impact our asset portfolios and the valuation of securities because they affect business profitability through global economic growth.

We are entering a period of geopolitical recession, with a risk of political volatility that hasn’t been seen since the Second World War. Nothing is unthinkable anymore.

The other consensus we reached was on the need to look for investment strategies that address geopolitical uncertainty. Our differences of opinion were more about when and how to take these risks into account when building a portfolio.

CDPQ I What key elements have you put forward regarding geopolitical-risk management at CDPQ?

C.B. I Addressing these risks begins with scenario analyses, which are developed every day at CDPQ based on internal and international expertise. From there, we establish probability measures, which are discussed and detailed in order to understand the impact our scenarios will have on our portfolios and to decide how to position ourselves.

At CDPQ, interventions are made in two parts. First, we look at the overall portfolio to determine the level of risk we’re giving ourselves. We take into account considerations that are strongly related to the economic environment and global growth. Second, we look at our investment decisions, whether in a particular sector or a business.

Take, for instance, a new cross-border tax in the United States. We may ask ourselves in which types of businesses we should invest. Should we choose businesses that benefit from local economies or large, global businesses? We have to look at the concentration of our investments at both the overall-portfolio level and the specific-securities level, so that we can adjust ourselves.

CDPQ I In light of the conversations you had with the other participants, what distinguishes CDPQ from other investors in terms of risk management?

C.B. I CDPQ has adopted guidelines that take into account the economic and geopolitical environment. We have developed a risk culture characterized by good governance, a good risk management system, a strategic decision-making process that weighs the pros and cons, as well as an investment process that establishes parameters where needed and promotes discussion and in-depth analysis.

What sets CDPQ apart – I heard it in conversations in London and, more recently, when speaking to credit agencies – is that the Risk management team is fully integrated into the investment teams. We see it in our practice of assigning business unit risk managers to each of the teams. This person works with members of an investment team on a daily basis, but has a different, even competing responsibility, which is analyzing risks. Meanwhile, the business unit risk manager receives help from the other Risk group members, whether from the quantitative analysis team that provides any necessary information or the qualitative team that thoroughly analyzes risk scenarios.

What sets CDPQ apart is that the Risk management team is fully integrated into the investment teams. We see it in our practice of assigning business unit risk managers to each of the teams.

At CDPQ, we also have teams that take a cross-sectoral approach to examining issues, across both sectors and portfolios, which is a rather unique practice. To fuel this risk culture in a positive way, we encourage discussion and value in-depth analysis. That’s not necessarily the norm elsewhere. In the world of finance, silos are often formed and risk limits and mandates are given to managers who are then left to themselves. CDPQ doesn’t work that way. The Risk Management team is involved in every analysis, decision and investment strategy. We encourage global strategies, which sets us apart.

CDPQ I Over the past few years, CDPQ has focused on an absolute-return approach. How has this strategy changed risk assessment and measurement?

C.B. I It changed it a lot. Before, we monitored deviations from the index religiously. Our system, framework and risk measures were all relative. It was based on the idea that the index was always right. All that mattered was that we performed a little better than the index without taking more risks. We were constantly measuring how much we were diverging from the index. Even when our absolute risk was comparable, the composition of our portfolio was more important. For example, if we had 150 securities while the index had 1000, there would have been a high level of active risk because the deviation was too high. So, we were encouraged to replicate the index and simply take slightly higher or lower weightings.

We have grown. Now, when we monitor our portfolio, we base ourselves on absolute risk rather than active risk. We measure global risk and the wider impact that crises have on our portfolio. Security-by-security deviations don’t affect the portfolio as such. We also reduced our number of securities, but we have a better understanding of the ones we do have. We can debate the securities because we know why we are taking such a position.

We have grown. Now, when we monitor our portfolio, we base ourselves on absolute risk rather than active risk. We measure global risk and the wider impact that crises have on our portfolio. Security-by-security deviations don’t affect the portfolio as such.

This goes beyond the Risk Management team. The investment teams have also changed their way of doing things and new measures are on the rise. We created a bottom-up and top-down process that fosters a symbiotic relationship and determines our performance.

Some of our peers are undertaking a similar process, but only a few. Many are still index-based. However, for us as well as for several of our Canadian peers, the move toward less-liquid assets calls for absolute-return management – whether in real estate, private equity or infrastructure. These investments require an absolute risk management system with an analysis that considers concentrations, type of activity and overall view.

CDPQ I What impact has the Global Quality strategy had on the risk level of CDPQ’s global portfolio?

C.B. I We’re talking about a major impact. This strategy contributed significantly to lowering the risk level of CDPQ’s portfolio. We invest in businesses that have a good cash flow, have been generating returns for a long time and are stable in the long term. These filters, the way we apply them and our concentration into these securities automatically lower our risk levels. The Global Quality portfolio is much less volatile than traditional indexes, which means less risk for our clients.

CDPQ I What will CDPQ’s main challenges be regarding risk management in the coming years?

C.B. I We made the decision to increase our concentration in less-liquid investments and to adopt a global approach, therefore further engaging in growth markets. We developed ways of addressing issues related to this strategy, but our work continues. Especially when it comes to strengthening our expertise on the ground. We are also paying close attention to challenges associated with less-liquid assets and building new tools to manage them. Finally, we’re developing tools that provide a cross-sectoral view for that type of asset where no market data is available.

Our risk culture helps us more forward. The risk integration system into our investment process helps us avoid cat and mouse behaviour that can be seen in risk management elsewhere.

Despite all the changes we made concerning governance, strategic planning and accountability, we still have work to do. But our risk culture helps us more forward. The risk integration system into our investment process helps us avoid cat and mouse behaviour that can be seen in risk management elsewhere. Our investment teams aren’t looking for ways to avoid getting caught. That’s not how we do things at CDPQ. Here, we know that everyone has their own point of view, and that’s normal. Not bringing anything up is what’s abnormal. We have to pursue our objective of leaving no stone unturned and maintaining our discipline.