Nest’s Mark Fawcett on why the hidden risks can matter the most

When most people outside of the financial services industry think about risk, they tend to equate it with negative consequences. It’s about exposing yourself to danger or putting yourself in a situation where there is a chance that something negative could happen.

For DC pension schemes, however, taking risk has a positive goal – growing our members’ money.

It’s certainly true that not all risks are rewarded. The relationship between risk and reward is by no means symmetrical.

Risk management is not about avoiding or even minimising risk, but trying to position your portfolios so as to take the right amount of the right type of risk, at the right time. This is the core tenet of NEST’s investment philosophy.

As investors, we don’t automatically chase the highest potential returns for our members nor do we choose the ‘safest’ lowest volatility option. Instead we look for exposure to the investments that offer the best returns in relation to a level of risk we consider to be appropriate to meeting our investment objectives, whilst being mindful of our members’ aversion to risk and loss.

“Risk management doesn’t end with measuring volatility”

NEST is an active risk manager. NEST’s default Retirement Date funds are invested according to a long term, risk derived strategic asset allocation.

What this means is, within the bounds of each lifecycle phase’s risk budget, we dynamically manage the asset allocation in line with asset class valuations and a global macro-economic and market ‘risk map’.  

There are at least two ways in which the upsides of risk can be optimised. The first is to set a benchmark for risk and seek to optimise returns accordingly. The second is to seek the optimum level of diversification within a portfolio.

By combining these two methods we believe that we can outperform portfolios that focus on any one method of optimisation in isolation. Our testing has so far borne this out.

However, risk management at NEST doesn’t end with measuring volatility and ‘Value at Risk’ (a popular measure of downside risk), or watching for signals from the Bank of England and the Federal Reserve – these are important of course but they are generally short term in nature and the market is usually pretty good at pricing them in.

There are therefore two important long term areas that we focus on.

The first is valuation risk. We will tilt the portfolio away from significantly overvalued assets – selling most of our gilts in October 2012 for example – and look for opportunities in undervalued assets where the risk/reward profile favours the long term investor.

Secondly we are concerned about the environmental, social and governance risks that companies expose themselves to, which the market often finds difficult to price until it is too late.

Just because the market finds these difficult to price, doesn’t mean they can’t be managed. We strive to be among the breed of investors who understand that poor corporate governance or poor environmental management can be ticking time bombs for asset values.

Any holistic risk-managed approach should aim to give these the attention they certainly deserve.

Mark Fawcett is Nest’s chief investment officer.