Assessing riskwhat your mutual fund

house does
In asset management, nothing is more crucial than managing risks. In the past few decades
mutual funds across the world have grown, managing nearly $87 trillion (about 75%) of banking
assets. This could not have been achieved without a thorough examination and assessment of
various kinds of risk.
While the asset management industry is exposed to several riskseach criticalnone is greater
than the risk of loss of reputation. For any asset management company (AMC), investing
peoples money is a matter of building a track record of good investment practices, careful
selection of investments in quality assets while optimizing the returns generated. It is very
crucial, therefore, that the AMC has strong risk management practices.
Banks and AMCs compete for the same funds. But unlike a bank, where investment mistakes
may show up gradually and recovery is possible over time, AMCs do not have the luxury of
mistakes. Such errors instantly reflect in a funds falling net asset value (NAV), and can hamper
the growth of the AMC. Besides, when there is a severe cash flow crunch, best mutual funds to
invest to liquidity shocks. Hence, AMCs are exposed to a significant downside if they err in the
investment process.
Types of risks
For an investor, the greatest risk, as succinctly put forth by the father of value investing,
Benjamin Graham, is the permanent loss of capital. In market parlance, risk is measured by
volatility, that is, the change in price of an asset. The bigger the movement in the prices, the
greater is the risk.
Generally, large AMCs have a dedicated team of risk managers, who oversee the portfolio risk.
They are independent of the investment teams and help in evaluation of the portfolio against
risk parameters.
AMCs strive to analyze all types of riskscredit, market, operational, liquidity, regulatory, and
so on. Credit risk is the risk of a decline in creditworthiness of the borrower or defaulter.
Market risk is the change in prices including interest rate and currency risks; operational risk is
the loss due to a failed process; liquidity risk is the lack of salability of an asset; regulatory risk
the change in regulations affecting a stock, sector or fund.
Risk management process

To manage risk, one has to measure it. The problem is that while some are easily measurable,
some are not. Holistically, while volatility risk can be measured; often event-related ones
cannot be.
As part of risk measurement, AMCs endeavor to forecast the future state of variables. Tools
such stress testing a portfolio and scenario analysis are regularly used to assess the potential
impact on a portfolio in times of extreme volatility.
Risk managers also keep a regular tab on key macroeconomic variables, e.g., money supply,
inflation, movement in investments by foreign institutional investors and event risks that can
have a bearing on a fund.
Investment risk in funds is key
The investment risk of a portfolio is also driven by the mandate of a fundthe nature or type of
assets it invests in. Investment risk is typically addressed by stipulating limits on exposure to
sectors or stocks. Thus, the fund managers are not permitted to cross a threshold.
While there is no concept of default risk in case of equity funds, they are exposed to other risks.
And those are fund structure risk (open-ended funds would inherently have higher sensitivity to
redemption pressure), fund capacity risk (evaluating investment opportunities in relation to the
market volume, particularly in thematic and sectoral funds), correlation risk (how an asset price
moves against another investment. A negative correlation may eat into the funds value, while
a highly correlated portfolio may not entirely reflect diversification benefits), and so on.
Counter-party credit risk is relatively lower in case of debt funds (which primarily invest in
extremely liquid money market instruments and government securities). Such investments,
however, are exposed to interest rate risk. Compared with debt funds, credit funds assume a
relatively higher counter-party credit risk. Skewed return profile (a cap on the potential upside)
makes it imperative that the investments justify the risk return trade-off. Funds tend to address
counter-party credit risk through proper client selection, adequate security and tighter
monitoring. Credit funds are also exposed to increased liquidity risk as liquidity of instruments
issued by corporate entities may be lower compared with government securities.
Other risks relevant for asset managers
Redemption risk is faced by all funds, equity or debt, from time to time. Funds may be suddenly
faced with severe redemption pressure, as was evident during global financial crisis of 2008.
During such an eventuality, a fund may then have to liquidate its investments at distress prices,
very often at a loss. Funds manage redemption risk by monitoring redemption requests and
holding adequate liquidity. Funds also tend to impose exit load to assuage the impact of
redemption prior to the stipulated period (while preserving the investors right to redeem).

Consistent application of valuation methods ascertaining the fair value of the investments,
while remaining compliant with the applicable regulatory and accounting standards, is key to
managing valuation risk.
In short, an AMC has to evaluate and monitor all these risks on a continuous basis. This can only
be done by instituting sound systems and proper processes, and strictly adhering to them.
Though risk cannot be completely eliminated, some of it can be controlled.
Asset managers need to prudently manage risk in their fiduciary capacity. The delivery of high
quality asset management services requires rigorous risk management practices, including
taking an enterprise-wide approach to it. For investors, they need to be aware of the fact that
they should not be selecting asset managers purely on the basis of returns generated from the
schemes invested. Instead, they need to prefer asset managers who are committed to risk
management.
This article was published in Mint on 7th October on page 20 written by Nimesh Shah who is
managing director and chief executive officer, ICICI Prudential Asset Management Co. Ltd.