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RISK MANAGEMENT STRATEGY FOR ASSET MANAGERS:

WHY, WHAT AND HOW?


MONEL AMIN HEAD OF RISK STRATEGY AUGUST 2013

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Table of Content
Introduction Why? What? How? Move beyond aggregation Introduce diversification in the risk framework Build a compliance culture Maintain robust and independent governance Pg. 6 Access to an independent perspective Better management of expectations Tailored understanding of risks Re-calibrated risk and return profile Pg. 5 Increasing risk interdependence Challenging macro-economic environment Transforming regulatory requirements Shifting investor focus Pg. 4 Pg. 3 Pg. 4

Next Steps Process driven by purpose Robust infrastructure foundation Multi-disciplinary risk managers

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August 2013 Insights|arthance

Asset managers are tasked with a dual mandate: consistently deliver superior riskadjusted returns and create a strong brand with long-term value. A strong risk culture is a key competitive advantage in achieving this goal. Introduction
Asset managers strive for an infinitesimally large sortino ratio. Given that the sortino ratio compares the return of the investment product with its downside volatility, the question is whether zero downside volatility can be achieved. The answer is conditional: this is likely when one takes a short-term perspective, but it is unlikely that one can achieve this in the long-run. Therefore, the best asset managers can achieve is the maximum sortino ratio possible both as an absolute measure as well as relative to the peer and asset class universe. Secondary to achieving superior risk-adjusted returns, but of considerable importance, is minimizing the cost of operations to maximize management company profitability. Every asset manager who strives towards this goal faces the reality of competing priorities, particularly because short-term performance falsely signals longer-term trends. Their choice among shortterm cost mitigation, long-term cost mitigation or longterm value creation is critical from risk management perspective. This pivotal decision has a downstream effect on the trade execution, operations and the risk infrastructure foundation and the firms risk culture. The true asset manager goal is to consistently deliver superior risk-adjusted returns and to create a strong brand with long-term management company value. While it may seem obvious to state, firms with a strong risk culture tend to be the ones that achieve this goal of building a sustainable business model. Risk culture is much more than leverage, Value at Risk (VaR) and stress testing. It encompasses enterprise wide risks such as liquidity, counterparty credit, regulatory, operational, fiduciary, reputation, and valuation risks. Although asset managers face different risks based on the type of strategy, underlying markets, domicile, investor base, and investment structures, three common risk culture elements are critical to their success [Figure below].

Strong risk culture requires a balanced investment in:


Multi-disciplinary risk managers Robust infrastructure foundation Processes driven by purpose

Good risk management delivers the following benefits:


Cost synergies in investment and risk analytics Enhanced strategic decision making

Efficient use of capital

Reduced probability of downside surprise

Reaction flexibility during stressed markets

Institutional signal to stakeholders

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WHY? Emerging trends have made investing in risk management crucial to achieving long-term success
Risk management has historically been less formal in the asset management industry. However, there are new and important drivers demanding renewed focus and investment in risk management. Increasing risk interdependence: Asset managers operate in a complex and dynamic environment, where risks change, converge and sometimes diverge over time. For the firms that are managing risks in silos, there is a need for integrated risk management to capture emerging risks and the possibility of a risk event; and to form a portfolio or strategic firm response to possible change in risk profile. The first integration is among interwoven risks such as investment, regulatory, operational, counterparty credit, liquidity and other risks via a simple, measurable, and dynamic dashboard. The second integration is that of risk management into the firms risk tolerance thresholds and associated decision making.

Transforming regulatory requirements: Increased regulation and the associated transparency demands in the form of Form PF/ADV, CPO-PQR, CTA-PR in the United States and AIFMD, UCITS in Europe create a need for institutional-quality risk management infrastructure. Lack of investment in infrastructure reduces the cost burden in the short-run, but creates a potential for operational risk in addressing these growing needs. Shifting investor focus: Sophisticated end-investors are looking beyond just a return track record and are increasingly asking to review historical risk taking and portfolio positioning to understand managers riskadjusted returns. Further, these end-investors continue to request transparency and detailed reporting as they focus on aggregating risks within their portfolios. This is a key due-diligence requirement, and asset managers that are not technologically equipped to meet these requirements often fall short of passing the duediligence, consequently facing difficulty in raising AUM.

WHAT? Independent view on manager risk profile


Often, risk management is viewed as a no-loss guarantee one thing it is not. Rather, good risk management provides the benefit of independent oversight as an overlay to the risk decisions taken by portfolio managers who are not tasked with the job of managing loss potential across a multitude of interconnected risk factors. Asset managers can achieve significant benefits with an effective risk management strategy: Access to an independent perspective: While a good portfolio manager, chief investment officer or a business head is the first line of defense and may be the best risk manager, a multi-disciplinary risk management team provides independent oversight over individual investment, themes, portfolio and firm-wide risks. August 2013 Insights|arthance

Challenging macro-economic environment: A medley of global growth challenges, sovereign uncertainty, policy decisions, and geo-political tensions translate into unpredictable asset moves. While this is an opportunity for the portfolio managers to outperform and demonstrate alpha generation, it inevitably comes with expanded risks and increased stress frequency. This makes it ever so critical to have the right tools to understand the range of risk scenarios and define a response to each scenario outcome. Further, illiquidity and correlation create a challenging investment environment with frequent drawdowns. This creates a need for practical risk mitigation strategies as well as complex drawdown management techniques involving multiple stake holders and competing priorities. 4|Page

Independent risk oversight allows for diversity in opinion in feedback and is a key success factor in engaging with institutional investors. Better management of expectations: Managing expectation across all stakeholders adds to transparency and builds confidence with the endinvestor base. It is important to limit the element of surprise by modeling known and unknown scenarios across all risk factors and creating tailored risk information. Tailored understanding of risks: Risk management framework should be tailored based on the investment strategy. For example, simulating a quantitative market neutral portfolio of equities with a standardized Black Monday scenario may not yield meaningful results, the same way VaR-based scenarios are not good measures for illiquid portfolios or portfolios constructed based on highly convex event risk. The risk of incorrectly dimensioning risk factors is acute when leveraging off-the-shelf risk solutions without appropriate customization. Additionally, the choice of off-the-shelf solution is increasingly driven by the need to meet investor and regulatory reporting requirements. However, these product solutions frequently have gaps such as drawdown and cash liquidity elements that are required for an effective market risk management framework. It is crucial to correctly analyze the universe of risk data for a given investment strategy and risk profile, and translate it into useful information tools, such as stress, liquidity and solvency models. Re-calibrated risk and return profile: Based on various risk information, how should a portfolio manager recalibrate risk and return profile, and how often, especially when risk levels are too high or too low? While excessive risk easily catches attention, little focus is given to too little risk. Too little risk is an equally significant challenge as it may very well avoid drawdowns, but will not meet investors long-term 5|Page

expectations and is a threat to building a sustainable business model. What is the most efficient path of translating risk information into risk decisions? Asset managers should avoid ad hoc decision making and incorporate multi-level thresholds to facilitate recalibration. Next to the decision on magnitude of risks, is leveraging risk awareness and maintaining the flexibility to shift from one risk focus area to the next. For example, redemption risk can become a prominent factor in investment allocation decisions if the manager has, over time, developed a concentrated investor base. During times of systemic stresses, liquidity and counterparty credit risks take on a higher priority. And, as with the recent developments in central counterparty clearing, collateral management takes the center stage for select investment strategies.

HOW? Execute risk management strategy as a competitive advantage


Move beyond aggregation: At an average asset manager, risk management is often synonymous with risk aggregation and reporting, partly because the environment suffers from a lack of institutional infrastructure and relies heavily on manual efforts. Risk management teams spend excessive time responding to reporting, data requests, and risk control needs instead of performing value-added risk management activities.

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Reality
Management

Balance
Management

Utopia
Management

Reporting

Reporting

Reporting

Control

Control

Control

Resource / time allocation

Credit: arthances future creative director August 2013 Insights|arthance

Asset managers need to leverage technology solutions as well as institute practical control process around reconciliations and data enrichment to operationalize basic risk measurement and monitoring elements. A robust infrastructure foundation is an absolute necessity for effective and value-added risk management. This allows for availability of timely and accurate information and allows the risk managers to focus on higher value-added pursuits. Introduce diversification in the risk framework: This is not to be confused with limiting industry, ratings, and geographical concentrations in portfolio construction framework, which is a topic too broad to cover in this paper. Rather, this refers to use of multi-perspective risk measures that capture the same risk in multiple dimensions, versus a single measure. As an example, after the 2008 financial crisis, there were two camps developing in terms of assessing drawdown risk potential. Some practitioners did not want to consider VaR as a risk measure; however, it is important to include VaR or its derivative in the mix of measures if appropriate for the underlying strategy. The 2008 crisis taught us not to place too much reliance on a single measure, but the answer is not necessarily discounting measures altogether either. Build a compliance culture: Setting smart portfolio construction or stop-loss guidelines and risk management and operational procedures is definitely important for successful portfolio management; however it is equally important to ensure discipline in adhering to such guidelines. These are three ways that asset managers have chosen to address this requirement: out-source the function, have the internal compliance officer perform this function or have the internal risk management function address this. The function is best performed by risk managers since this requires knowledge of products, securities and developments in the capital markets, and at times may

require optimizing framework.

the

portfolio

construction

Maintain robust and independent governance: Having accurate and timely information around the right risk measures is important, but lack of clarity around escalations and governance may result in risk management failure. It is important to establish strong governance around escalations, remedial actions and threshold-driven decision making. This eliminates ambiguity and speeds up the response to a risk situation. Equally important is the independence of risk management. Often, risk management is a responsibility of the Chief Investment Officer, Chief Compliance Officer, or the Chief Operating Officer depending on the evolution of risk culture within each firm. With the exception of larger firms, a dedicated risk management function is a luxury that mid- to small-size asset managers cannot afford. Having a dedicated Chief Risk Officer (CRO) allows for better focus and planning and consequently results in more structured responses to risk situations. In addition, the asset managers internal ecosystem could at times be too small to allow 100% independence. Further, the Board of Directors structure is also less robust compared to large financial institutions, driven by fewer stake holders and less systemic risk posed by a single entity. So, the asset manager needs to work harder in structuring independence and limiting conflict of interest within the firm.

Next Steps: Address the risk culture deficit


Recent well publicized risk management failures in the asset management industry have been a result of operational failures driven by fraud and/or lack of August 2013 Insights|arthance

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independence; drawdowns resulting from excessive leverage and concentration, and/or governance failure. These failures come with substantial costs in terms of large drawdowns, damaged reputation, and loss of business viability. All of these, in hindsight could have been avoided by a small investment (equivalent to a fraction of the cost of failure) in risk management. It is imperative for asset managers to periodically assess their risk management strengths and weaknesses. This is the first step to identifying key action items required to establish a strong risk culture that delivers continuous improvement to achieve the dual mandate of sustainable returns and management company value. Process driven by purpose: Adopting good practices and a governance structure or restructuring risk processes does not need to be particularly expensive in terms of time and resources. At the same time, a onesize fits-all solution is not recommended. Asset managers must carefully consider a balance between firm and portfolio specific business requirements in designing these processes to meet the risk management objective. Robust infrastructure foundation: While in-house infrastructure investment may not be the right choice

for all firms, there are several third-party alternatives, with strengths in specific components across the spectrum of overnight risk modeling, risk aggregation, performance analytics, investor and regulatory reporting that should be considered. However, asset managers should perform in-depth vendor duediligence and create a series of partnerships to formulate a streamlined operational and risk infrastructure, while taking advantage of pioneering technologies such as software as a service, cloud offerings, and big data analytics. Multi-disciplinary risk managers: Finally, the most critical element of risk culture is engaging with the right risk professionals. These professionals should: possess multi-disciplinary risk expertise beyond market and investment risk, understand the breadth of products and the markets of the investment strategy, have in-depth understanding of applicable risk issues, be able to foster communication with various stakeholders, and offer independent perspectives as part of a robust governance structure.

About the author


Monel Amin is Head of Risk Strategy at arthance, a global risk management firm for the buy-side industry. arthance provides strategic risk management capabilities to institutional investors and asset managers in the form of advisory, execution and independent Chief Risk Officer offerings. The firms institutional investor practice is focused on market and investment risk offerings for family offices, pension plans, endowments, foundations, and wealth funds. The asset manager practice is focused on enterprise risk offerings for long-only managers, hedge funds, and hybrid structures. Linkedin | Twitter | Facebook | www.arthance.com

This document contains general information only and arthance is not, by means of this document, rendering risk management or other professional advice or services. This document is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your firm. arthance shall not be responsible for any loss sustained by any person who relies on this document. 2013 arthance llc 7|Page August 2013 Insights|arthance

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