Educational Series Vol. 3 - Risk Management
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Should Risk Management Become Uncertainty Management?

By Associate Professor Mick Swartz, Ph.D. (Finance), CAIA in the Finance and Business Economics Department at the University of Southern California. Professor Swartz is on the Board of CalALTs.

March 2013

 

There are many challenges facing hedge fund managers but perhaps the greatest of these is that fact that the world today is filled with many new risks, or perhaps more appropriately new uncertainties, that were not present five years ago. Since the financial crisis of 2008, the investment landscape has changed dramatically and it continues to change almost daily as governments around the world aggressively intervene in markets with new fiscal policies and legislation. Exacerbating the effect of aggressive government intervention is the fact that today, news travels instantly across the globe and a hedge fund’s investment strategies and traditional risk management practices are often forced to adjust in real time. 

While most view risk and uncertainty as essentially being the same thing, over 70 years ago the noted “Chicago School” economist Frank Knight made an important distinction between the two concepts that remains highly instructive today.  Specifically, Knight argued that “risk” is a concept of probability in which the underlying probability distribution is known and can be estimated (within a certain margin of error while “uncertainty” is a situation in which a great deal is unknown and one cannot estimate the underlying distribution.  This distinction is critical and an important consideration when assessing investment strategies and the managers that implement them.  

Many would argue that in the pre-2008 environment, and certainly in the environment proceeding the era of the internet and related digital communications, the range of possible market outcomes from various government activities was at least somewhat knowable and to some degree predictable using accepted statistical tools.  Therefore during this era, asset managers were faced largely with questions of “risk” and using the statistical tools available to them, they could engage in fairly effective risk management. 

Today however, thanks to heightened government intervention and instantaneous global communications, world events and political factors seem to affect asset prices much more quickly than ever before. As a result, government actions from China to Spain to Australia or anywhere else can affect asset prices almost instantly. Moreover, the market impact of tax changes, asset purchases, interest rate changes and guidance by central banks is much less quantifiable than ever before. As result much of what asset managers now face is not risk but really, uncertainty as defined by Professor Knight. 

This uncertainty is made particularly acute by the constant changes in the cast of decision-makers that make up global governments, changes that have the potential of significantly altering the value of assets and especially, illiquid assets). For instance, the open question of who will be making important central bank or political decisions two years from now in Greece, Spain, Japan or France greatly affects the  approach an asset manager should take toward not only assets in those nations but in the many assets that will potentially be affected by changes in the prices of assets in those nations including global currencies and global debt, both sovereign and corporate Likewise, the actions of the Federal Reserve have in the eyes of many become much less predictable in recent years and as a result cannot be as well quantified as they once were. This again makes one’s ability to predict the values of bonds, stocks, real estate and other assets much more difficult than ever and as a result, the investment environment contains a great deal more uncertainty than in the past. 

For all of these reasons, it is clear that investment professionals’ traditional risk management approaches need to be reconsidered at this time and should likely start incorporating large doses of “uncertainty management” as well. What is “uncertainty management?”  It is a more comprehensive assessment of the future that, among other things, considers how governments will react to social and political changes and includes the possibility of unknown, extreme outcomes that are beyond the reaches of probability models. Uncertainty management considers how often and how radically governments will change if unemployment rates remain at historic records in Europe? Uncertainty management considers how often finance ministers will change in Japan if the economy does not bring economic prosperity to the middle class? Uncertainty management considers how economic policies in China and Singapore will change if the distribution of income widens? Uncertainly management considers what level of debt burden investors in US Treasuries will allow before the market starts to penalize the excess spending of the US government?  

In short, uncertainty management asks tough questions and assumes extreme political situations and market outcomes in a way that pre-2008 risk management models did not.  The complex and continually evolving world in which hedge funds are investment demands nothing less.

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