How to Manage Risk in a Pandemic
“How do you talk about risk in ways that everybody can understand?” Karyn Williams says that’s a crucial question these days. Williams, the founder and managing principal of Hightree Advisors, says, “Risk is the most important decision an investor makes,” and that lesson has been brought home by the stock markets wild ride amid the coronavirus pandemic.
But there’s a distinct lack of symmetry in discussing risk and return. Returns can be calculated to the third decimal place using well established conventions and methodologies that enable everyone to agree on the same numbers. Risk is much more elusive and amorphous. Academic metrics like standard deviations seem silly to non-academics who don’t regard price appreciation as a “risk.” Ultimately, Williams says, many investors are unable to “tell you how these metrics are linked to their objectives, so there is a huge communications disconnect.”
Hightree is trying to improve communication by using new metrics that investors can understand, and that link risk with return and other investment process choices. At many institutions, Williams says, “Investments end up being evaluated in a silo,” and the portfolio may not fully reflect the underlying purpose of the institution’s investments. “If you’re on the board or the committee, if you have one measure that’s disconnected from the process itself, you’re going to see risk as separate,” she says, “and that’s a problem.” Hightree seeks to address these kinds of problems and provide clarity in analyzing risks.
Before she began setting up Hightree in 2018, Williams was Head of Client Solutions at Two Sigma, a systematic investment manager, and before that she was CIO at Farmers Group, Inc. In September 2019, Michael Dudkowski joined the firm as a principal and managing partner after a long stint as a senior consultant at Towers Watson Investment Services. And in April, Lisa Laird came on board as a principal and senior advisor. Laird had been CIO of Providence St. Joseph Health, overseeing some $18 billion for Providence which runs 51 hospitals across sevens states. Before that, like Dudkowski, she was at Towers Watson, and all three principals are alumni of Wilshire Associates. These days, the firm has been engaging with clients for a number of assignments which have focused on risk as well as governance. Its principals have worked with client investment programs ranging from tens of millions to billions in dollar size.
To help clients understand the interplay of risk and return, Hightree offers a proprietary methodology that relies on two new metrics with Greek letter names: Portfolio Pi and Eta. Pi measures the average probability that an investor will reach desired investment outcomes. These desired outcomes might include things like achieving returns three 3%.
Meanwhile, Eta measures whether the changes are worth it. If an investor’s changes move Pi up or down 10percentage points, Eta measures the value than the investor might gain or lose by making those changes. For example, Eta would indicate what it would cost in likely dollars or returns to decrease the probability of suffering a drawdown of more than 5%.
Like so many formulations in finance, Pi and Eta ultimately depends on the investor’s own assumptions and expectations about market behavior, but they force investors to be more rigorous in talking about what they want and expect in terms of risk and return.
Hightree doesn’t do the kind of general investment consulting that its principals did in their Towers Watson and Wilshire days. “What we do is different, and we don’t compete head to head. We work with and alongside other consultants,” Williams says.
But Williams thinks recent events are going to ramp up investor focus on risks, just as the 2008-09 financial crisis launched countless discussions of tail risk, black swans, and thousand year events. This heightened focus on risk might seem like good news for Hightree, but the bad news is its principals are sheltering in place just when they might want to be out pitching their wares to shell-shocked institutions. Williams says, “There are many people we already know who don’t need to see us in person.” Still, she acknowledges, “There’s only so much you can do on Zoom.” Well, that’s one of the risks of starting up in a pandemic, and if there’s one thing Hightree is attuned to, it’s risk.
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