The Use of Value at Risk by Institutional Investors

I n recent years, risk management has been of growing interest to institutional investors, including pension funds, insurance companies, endowments, and foundations as well as the asset management firms that manage funds on their behalf. Traditionally, institutional investors, and particularly pension funds, have emphasized measuring and rewarding investment performance by their portfolio managers. In the past decade, however, many U.S. pension funds have significantly increased the complexity of their portfolios by broadening the menu of acceptable investments. These investments can include foreign securities, commodities , futures, swaps, options, and collateralized mortgage obligations. At the same time, well-publicized losses among pension funds, hedge funds, and municipalities have underlined the importance of risk management and measuring performance on a risk-adjusted basis. One approach to risk management, known as Value at Risk (or VaR), has gained increasing acceptance in the last five years. However, institutional investors' quest for a VaR-based risk-management system has been hampered by several factors. One is a lack of generally accepted standards that would apply to them. Most work in the area of VaR-based risk measurement and standard-setting has been done at commercial and investment banks in conjunction with managing market risk. VaR originated on derivatives trading desks and then spread to other trading operations. The implementations of VaR developed at these institutions naturally reflected the needs and characteristics of their trading operations, such as very short time horizons, generally liquid securities, and market-neutral positions. In contrast, investment managers generally stay invested in the market, can have illiquid securities in their portfolios, and hold positions for a long time.