Managing Investment Risk

Comprehensive, methodical risk management is a hallmark of UTAM’s investment approach. Our risk framework has continued to evolve as we reflect on insights from our earlier approaches and new advancements in risk management. Led by our Chief Risk Officer, UTAM’s dedicated team examines multiple dimensions of risk – from counterparty concentration and liquidity needs to ESG issues and climate risk – to ensure that all investment decisions reflect the risk appetite and long-term expectations established for the university’s Endowment portfolio.

Our investment risk management framework is focused on the following three risk categories: market, concentration (including credit and counterparty) and liquidity. The main portfolio risk constraints, such as the active risk budget, are approved by the university administration and various committees, including the Investment Committee. We incorporate these limits into our processes to ensure that any risk we assume to earn returns in excess of the Reference Portfolio is managed in a thoughtful and efficient manner. To that end, we manage the risk of the Endowment portfolio against the university’s specified active risk budget and incorporate several limits on exposure, concentration and liquidity.

A Comprehensive Risk Management Framework

Market Risk

UTAM identifies, measures and monitors a variety of risks on a point-in-time and trend basis (i.e., over time) using a third-party holdings-based risk system. We begin by loading all available investment holdings from our managers into the system on a monthly basis. Where positions from a manager are not available, we use a variety of statistical techniques to model the most relevant risk exposures of those managers. For private investments, such as private equity and real estate, we use multi-factor proxies that reflect the key risk drivers of the investments. For certain credit strategies where position-level cash flow data is available, we employ a discounted cash flow model that accounts for illiquidity and credit risks.

Once we’ve populated the risk system with holdings and proxies, we measure active risk (i.e., portfolio risk minus Reference Portfolio risk) and total portfolio risk (i.e., the absolute level of risk in the portfolios). In both cases, we identify specific risk contributors by asset class, investment strategy, investment manager and position. We also monitor the exposures of the Endowment portfolio to different sectors, geographical regions and credit-rating categories. (For the EFIP portfolio, we apply other risk monitoring and measurement techniques appropriate to those holdings.)

In addition to the risks highlighted above, we assess the highest risk concentrations among individual issuers across a variety of categories. We estimate the sensitivity of the portfolio to potential changes in market risk factors such as equity market shocks, shifts in interest rates and credit spreads, and adverse movements in foreign exchange rates. We also run the portfolios through historical stress periods such as the 2008 global financial crisis and the 2020 market correction due to COVID-19. These analytics are all integrated through simulation analysis to assess the possible portfolio impacts and sensitivities to different capital market regimes and scenarios, including a severe global market downturn. To complement the risk system analysis, we also have the capability to run our own asset liability modelling using a dynamic scenario generator. This allows us to analyze the behaviour of the assets and liabilities of the Endowment portfolio across different plausible forward-looking scenarios. This set of analytics provides insight into the potential path-wise behaviour of the investment strategies in the portfolios over longer horizons and across a breadth of scenarios that may not be present in the historical data.

Our analysis draws on multiple metrics to provide insights into overall risk exposures and identifies specific markets, factors and regimes to which the portfolios are most vulnerable. The output of this analysis is discussed at regular meetings of our Management Investment Risk Committee and informs our decision-making on how these risks (on an absolute and relative basis) should be managed going forward.

ESG and Climate Risks

As part of our assessment of market risk, we’ve researched and developed analytics to support total portfolio ESG and climate risk analyses. Our risk reports now include both exposure-based and scenario-based analyses, which are directly integrated into our market risk management framework. Driving the exposure-based analysis is the application of several sets of E, S and G scores. We use these scores to study the portfolios’ vulnerabilities to various ESG factors. For climate risk in particular, we use risk indices and scores that capture a country/sector’s current state and its readiness to adapt to a low-carbon economy. These metrics, which can be tied back to individual asset classes, provide information on which areas of the portfolio could be most susceptible to ESG and climate-based risk shocks on both a stand-alone and relative basis (i.e., relative to the Reference Portfolio).

The exposure-based analysis is complemented by the scenario-based modelling, which shows how the portfolio could perform under various climate scenarios. For individual E, S and G factors, we have developed in-house stress scenarios guided by past market events (e.g., natural disasters, epidemics, cyber-attacks, impeachment). In each case, we have identified the key risk factors and use this information to propagate shocks through the broader market. For climate risks in particular, we have integrated transition and physical risks outlined in the academic and practitioner literature. Here we have used both external platform tools (e.g., PACTA) and in-house-developed scenarios. Guided by published market scenarios (e.g., IEA transition scenarios), we have translated climate shocks into changes in macroeconomic variables and subsequently into asset price shocks. This analysis allows us to propagate path-wise climate shocks across countries and sectors. While we’ve made good progress so far, this remains a key research area for us.

Working alongside the UTAM team, we provide the risk systems and data management tools they need to evaluate risk and exposures across multiple asset classes, as well as the total portfolio – and together we’ve developed custom analytics to gauge risk from many different perspectives. UTAM continually challenges us to take the analysis even deeper as we deliver the quality of insights that UTAM needs to manage the University of Toronto’s Endowment investments for the long term.

Zoubair Esseghaier, Head of Investment Analytics North America, State Street Global Exchange

Liquidity and Counterparty Risk

To ensure the portfolios have adequate liquidity even under stressed market conditions, we created an internal model that calculates the potential liquidity needs of the Endowment portfolio. This helps ensure that adequate cash and other sources of liquidity are available to meet all liquidity needs over various analysis horizons. This analysis includes a point-in-time evaluation of the portfolio’s liquidity profile and how it could change over different scenarios. This approach to liquidity modelling ensures that we could rebalance the Endowment portfolio back to the Reference Portfolio target asset class weights even in a stressed market environment without having to sell assets at a significant discount.

The Endowment portfolio has credit exposures to individual counterparties through security holdings in the equity and bond markets. We also generate credit exposure through the use of derivatives, which are mainly used to hedge foreign exchange exposures and to rebalance the portfolios back to the target asset class weights of the Reference Portfolio. We establish fixed limits for individual counterparties that we monitor regularly to ensure that the portfolios are not overexposed to negative shocks from any single counterparty. We have the ability to run exposure reports on a daily basis, which provides our internal teams with up-to-date information on the portfolio’s credit exposures.

Bringing It All Together

We believe that a robust and disciplined risk management framework is critical to the long-term success of an active management investment program. In every area of risk assessment, as we analyze data on underlying positions and historical returns, we gain deeper insights into the risks in the Endowment portfolio and in our investment managers’ portfolios. It’s a continuous process that starts right from the initial due diligence phase of our manager selection process.

The Investment Committee and the university administration view the active risk, liquidity, counterparty and other limits as sufficient to give UTAM the flexibility to achieve our value-added objectives – but not so large that they put the portfolios at undue risk of significant underperformance relative to the Reference Portfolio.

UTAM’s Active Risk Budget

The amount of risk that UTAM is permitted to use in the actual Endowment portfolio is constrained by the “traffic light” risk framework shown below. Active risk is defined as the risk in the actual portfolio minus the risk in the Reference Portfolio. For example, the “green zone” extends from taking 0.50% less risk than the Reference Portfolio to 1.50% more risk than the Reference Portfolio.

Active Risk ZoneActive Risk
Green (“Normal”)-0.50% ≤ Active Risk ≤ 1.50%
Orange (“Watch”)1.50% < Active Risk ≤ 1.75%
Red (“Reduce”)Active Risk > 1.75%

Management Investment Risk Committee

Overseeing all of our investment risk activities is the Management Investment Risk Committee (MIRC), chaired by our Chief Risk Officer. This Committee is also responsible for developing investment risk policies, reviewing risk reports, reviewing client portfolio investment risk positions and addressing all investment-related risk issues.

The Committee is composed of the Chief Risk Officer (Chair), the President, members of the Risk & Research team, and the Investment Heads.