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Alan Picone, Duff & Phelps

Evidencing risk management within the investment strategy is music to institutions’ ears


Risk management has mutated under AIFMD, causing risk managers to become more involved in the portfolio management process from an ex ante risk perspective. As investors become more educated on the risk function, managers who can demonstrate an independent, robust risk management environment have the potential to improve their capital raising capabilities.

Historically, risk management has always been viewed as a tactical function within hedge funds and has tended to operate in the background. But AIFMD regulation and increased investor due diligence is making risk management a more strategic function, causing risk managers to become increasingly involved in the capital raising process.

This is the view of Alan Picone, Global Head of Risk and Management Company Solutions at Duff & Phelps. 

“Broadly speaking, one of the main aspects of regulation is to make sure that there is an element of systemic risk preservation. We talk often about investor protection under AIFMD but what is the investor perception in all of this?” asks Picone.

“In my opinion, the role of the risk manager has become magnified under regulatory evolution. There needs to be independence under AIFMD, with risk management providing a counterbalance to the portfolio management function. There has always been good governance of risk processes in hedge funds, but what is different today is that it is written in black and white.” 

The fact that the risk process is codified in the regulatory tome that is AIFMD, has led to a mutation of risk management; one that requires fund managers to adopt a far wider, holistic approach to risk management. Those that can demonstrate this are going to be viewed more favourably by institutional investors, at a time when getting one’s investment strategy in front of institutional eyes is more challenging than ever. 

Picone says that from a technical perspective, risk managers must not only rely on their fundamental expertise in managing risk, they also have to bring an element of gravitas to present the risk management process at the boardroom level. 

Risk, in no uncertain terms, has become a multi-faceted and far-reaching role. 

The combination of technical excellence plus being influential within the higher echelons of an asset management group, has become one of the main challenges that risk managers have had to confront, says Picone.

“Looking at risk is no longer confined to financial/market risk, it means having a more holistic view that encompasses every single source of risk that an asset manager is exposed to: operational risk, compliance risk, regulatory risk, liquidity risk etc., that could ultimately affect not only the performance of the fund, but the perception among investors. 

“The risk management paradigm, in my view, has changed. It has multiplied such that risk now touches upon every aspect of an asset manager’s business,” comments Picone. 

Risk management influencing managers’ distribution prowess

One of the upshots to this supercharged risk management function is that it is becoming a more integral part of the capital raising process; a new cog in the distribution wheel. In economic terms, the problem that hedge funders face is that the supply vastly outstrips demand. Each day, managers have to think about how best to optimize their distribution channels and extend their reach. 

Picone thinks that risk management is one way to address this challenge. 

“We work with both GPs and LPs, and we see a demand from LPs to look under the bonnet, and assess the risk management function independently. It has become a key investment criteria and an integral part of an institution’s due diligence process. 

“Fund managers are beginning to realize that there is a big potential for risk management to become a revenue-generating function. And that if they can line up good risk professionals in front of investors with the ability to communicate risk in an articulate way, it can go a long way to getting the box ticked with that institution. 

“To my mind, risk management is becoming more of a strategic function as opposed to a purely tactical one,” opines Picone. 

Ex ante not just ex post

In many respects, AIFMD has helped to push risk management to the next level. The regulation makes it quite clear that risk management has to become more closely intertwined with portfolio management, meaning that risk managers must consider ex ante risk at the pre-trade, position building level in a portfolio, rather than merely focus on ex post risk. 

The optics of risk management have therefore changed. It is no longer a case of applying risk measures afterwards to measure the potential impact of trading decisions; this rearview mirror approach to risk has now become a frontview mirror approach under AIFMD.

“We see more interaction of the risk management function with the portfolio management function; these have always been embedded to some extent in hedge funds but not to the degree that risk management becomes, so to say, intrusive. It requires a number of critical tasks such as risk attribution, margin-at-risk impact and so on. Ex ante risk makes sure you remain on track and along the lines of the fund’s objectives,” says Picone. 

In other words, says Picone, ex ante risk has become “more systematic”. Some of the larger hedge funds have long had in place robust processes to embed risk management as much as possible into the portfolio decision making process at the pre-trade level. Under AIFMD, all managers are required to adopt this mindset.

“When you actually look at the risk prescriptions under AIFMD, managers do not necessarily have every aspect of risk management in place. There will be gaps, and we help our clients to address those gaps when necessary. It would be a great pity to have a robust, sophisticated infrastructure on the ground yet overlook certain risk management functions,” adds Picone. The implication being that it could lead to the manager getting rejected by an institutional investor. 

Investors want evidence of independence

Investors do not necessarily seek to understand the quantitative aspects of risk management given the complexity of the role but what they are doing is looking for several qualitative factors as part of their decision-making. 

The first, and perhaps most important of these, is evidence that the fund manager is truly independent.  

When investors realise that the risk management function is completely separate from the portfolio management function, with clear Chinese Walls in place, it is regarded as a big plus point for the manager. 

“If you take 10 asset managers, chances are each one will have different operating models for managing the risk functions; (the level of independence will vary) but it has become a key element. When there is a suspicion that the risk manager is also the portfolio manager, it can create frustration with investors,” says Picone. 

The second factor that investors consider is the presence of risk infrastructure and risk systems with technology. They want to see evidence that risk is being managed with robust technology and tools. 

“The third factor that investors want to see before putting a large ticket on the table is that the risk management function meets their investment requirements: beyond technical points of calculating risk there may be requirements such as the ability for the strategy to invest only X per cent in a certain asset class, for exposure levels to remain within certain limits and so on. The end result of this is that investors can get risk reports that are tailored specifically to their needs, as opposed to standard risk reports,” explains Picone. 

In other words, does the risk manager have the flexibility to be able to meet the idiosyncratic requirements of the investor that accurately reflect their risk appetite? To determine this, large institutions will often ask their own risk teams to engage with a fund manager’s risk team, again further illustrating the point that risk managers are becoming a key part of the capital raising process.

The above are all important factors that will go in to an investor’s due diligence exercise before deciding on where to allocate capital. 

Equal pegging

With global hedge funds beginning to embrace AIFMD, the role of the risk manager is set to become even more critical to a fund’s long-term success. As they move out of the shadows and more in to the front line, one could argue that risk managers are on an equal pegging to their portfolio manager colleagues. 

“If not more so,” says Picone. “A portfolio manager who can demonstrate a good track record is a statement of fact, you would expect that when going out to raise capital. It’s a given, otherwise investors wouldn’t be meeting with them. What is a differentiating factor today is the extent to which the risk management function is evident within the fund strategy. When you talk to pension funds, that is music to their ears. 

“As opposed to performance, managers are able to talk about risk-adjusted performance, about the risk-reward compromise within the strategy and so on. This is not fundamentally new, but I want to reiterate my belief that risk management has mutated from just a tactical exercise to a strategic exercise.”

Ultimately, what AIFMD has done is to extend the scope of risk management. 

Risk used to be a technical exercise. That is no longer the case. 

“It has become an important element of a fund manager’s distribution capability. It gives risk managers the possibility to be more influential in hedge fund groups,” concludes Picone. 

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