Investors, and their advisors and intermediaries, have traditionally decomposed risk factors in many different helpful (and sometimes not so helpful) categories. Within traditional corporate finance, so called “risk stripes” include well known categories like market risk and credit risk. I see a new and very significant category emerging: dynamical risk.
In recent years, an un-glamorous revolution has been taking place under our noses: the attempt (finally some might say) to make a serious effort at quantifying risk that does not fall into traditional categories.
There is not yet a universally recognized name for this “grab bag” of “other” risk. But it variously goes by the distinctly drab moniker of operational risk, or even worse and no more descriptive, non-financial risk. These risks include all the hard to quantify sources (cyber, legal, reputational, environmental, etc.) of potential gain or loss (too often framed only with respect to loss) that can affect an investor.
Of course, these are hardly non-financial risks, and they can lead to material financial impacts. As I wrote a few years ago in American Banker: key to understanding risk is capital. The largest banks have recognized the impact of operational risk. For instance, J.P. Morgan reported (as of 12/31/19) risk weighted assets (RWA) for operational risk as 28% of the total, leaving the obvious category for a bank — credit risk — with only 66% and dwarfing market risk with more than five times the RWA allocation.
Some may wonder if these trends apply outside the rarefied world of the Basel III Advanced Approach to Bank Capital. Of course it does, and some of the most sophisticated players in asset management are beginning to lead in this revolution. Well-known “factor investing” pioneers at AQR Capital Management have recently realized the importance of this, winning “Asset Manager of the Year” at the 2019 Operational Risk Awards, for work in precisely this sector. Finally, leaders in private equity and alternative data have all begun to realize the significance of understanding the operational risks and rewards that were previously buried within portfolios.
Into the fray of what increasingly looks like a kind of “non-financial risk revolution,” it is clear there are now whole new realms of risk and opportunity for an investor to understand. The one that has captured my attention most and which I now propose as a brand-new risk factor — more properly a genus of related risk factors — is dynamical risk.
To the non-physicist (yes, there still are such people in the world of finance), it is worth pointing out that “dynamics” is the aspect of physical science which describes how systems change over time. The dynamics of a physical system refer to its foundational causal features. These features drive, usually, a variable set of outcomes. On the micro-scale, this is often best described by quantum mechanical means. For the investor, however, dynamics is the world of predicting physical outcomes based on empirically developed mathematical models.
Dynamical risks, as I mean here, are those risks to an investment thesis that are driven by the physics of underlying real assets. A good example near to my heart, as the former head of J.P. Morgan’s Reservoir Engineering and Technical Analysis team, is the complicated geophysical properties of oil and gas wells. Equally salient are the physics of wind and solar power generation, storage, and transport.
With the availability of vast troves of alternative data, and the computing power to handle it, dynamical risk is not a purely academic concept. In fact, dynamical risk has always been there, but now it can be quantified in helpful ways. Whether they know it or not, investors are in a race to take advantage of the opportunity these developments present, using both old and new techniques, such as artificial intelligence and deep learning.
It is now becoming clear that many of the previously significant investment factors can be further decomposed into dynamical risk. In recent years, some have despaired that the golden age of creativity in finance is over. Taking the challenge of understanding dynamical risk has the potential to breathe new life into the way investors think about their portfolios and achieve their goals.
My hope is that we are now only at the start of a new period of thoughtfulness and effectiveness in deploying capital to obtain superior returns for investors and to provide for the capital needs of our complex economies. Understanding dynamical risk is on the horizon of this new beginning.