By James Williams – “It seems to be a law of nature, inflexible and inexorable, that those who will not risk cannot win.” – John Paul Jones
The Holy Grail for any portfolio manager is to find a way of maximising their investment returns by taking the least amount of risk. Fine in theory. Difficult in practice. As managers continue to access hitherto inaccessible markets in the elusive search for alpha, they are exposing themselves to more investment risk. Effective risk management has become a vital exercise as a result.
Swiss-based Harcourt Investment Consulting is the alternative investment and advisory arm of Vontobel and runs a number of hedge fund-of-funds as well as two actively managed commodity funds – Vontobel Belvista Commodity fund and Vontobel Belvista Dynamic Commodity fund. Speaking with Hedgeweek, Bruno Melo (pictured), Head Portfolio Risk Alternatives at Vontobel Asset Management, says that the most important facet of risk management is liquidity risk given that both funds are UCITS-compliant.
“Both funds offer daily liquidity so we have to be sure that the instruments we are dealing with are highly liquid. If you’re looking for alpha and you want to explore new markets and new instruments you have to be sure that the liquidity is there. We use a combination of risk management systems – in-house systems plus systems from companies like RiskMetrics and Bloomberg. That gives us comfort when trading new instruments,” says Melo.
To keep within regulatory guidelines it is also essential that VaR limits are closely monitored. The fact that this number is also easy to communicate to investors for their own understanding means that as far as Melo is concerned, VaR “remains the key risk measure.
“We also use parameters such as conditional VaR, gross and net exposure by sector, as well as exposures for each individual security. Neither fund can be too concentrated in any one single commodity contract or sector.”
Operational risk is, it could be argued, just as important for today’s hedge fund COO as market risk is to a firm’s CIO. Investors increasingly want demonstrable evidence of the processes and controls in place to monitor counterparty risk, disaster recovery plans, regulatory compliance and reporting expertise, not to mention the day-to-day risk solutions in place to manage portfolio risk.
New York-based South Ferry Capital Management LP is an event-driven credit shop established by John Reilly in 2010. At the beginning the firm used its administrator, Northern Trust, to provide a basic Bloomberg-driven risk solution. This, explains Marshall Terry, COO, was fine for the first 18 months or so but as the fund grew and regulatory and investor demands become more onerous, it became apparent that a more consolidated solution was needed.
“We went out to look for another vendor to complement our administration solution with Northern Trust. We ended up partnering with ConceptONE. The solution has helped transform what was a manual pivot table process into an automated process where our daily risk numbers are turned into exposure sheets, which we use to internally disseminate to investors/prospective investors. It’s making sure there’s continuity in the data as it comes through the system,” says Terry.
Prior to this the firm was doing its exposure calculations in Excel but it quickly became apparent that this was too time-consuming and “ripe for error” in Terry’s words. The ConceptONE solution creates a more automated, efficient workflow. This naturally benefits the front and back office as they all have access to the same risk data.
This creates a form of “operational alpha”. It’s what a lot of today’s successful managers are looking to put in place to show investors they mean business.
It also leads to what Terry refers to as having a more holistic view of risk management.
“Traditionally, because of the way firms have built their infrastructure over time as demands changed, there has been a siloed approach to producing risk data, investor data and regulatory data. When we mapped out our infrastructure development plans, we wanted to ensure that we built our risk and regulatory reporting infrastructure so as to ensure the same data set is being used to populate our exposure sheets, our internal risk numbers, and our regulatory reports.
“What we and many firms are now doing is taking a holistic approach to risk management. We have limited resources so we have to be strategic in how we go about doing this, which involves finding vendors that are willing to work with us and customise something for us; that’s key.”
Adopting this comprehensive view of risk has long been a conceptual approach endorsed by SkyBridge Capital LLC, one of the world’s leading hedge fund of fund and advisory firms with approximately USD7.7billion in AuM and under advisement.
Tatiana Segal is the firm’s head of risk management. Segal notes that portfolio transparency has increasingly been a factor in raising institutional assets and has been an area of evolution at the firm. Complementing its existing risk framework, which incorporates a proprietary Hedge Fund Analytics application, SkyBridge has hired the RiskAggregator solution provided by Imagine Software.
The resulting risk platform offers both returns-based and position-based analytics.
“We partnered with Imagine Software because they have long-standing expertise in delivering portfolio risk analytics in sophisticated structures and being able to engineer tools for esoteric risk,” confirms Segal.
Segal confirms that the majority of SkyBridge’s AuM sits on the Imagine Risk Aggregator platform.
“The team has always believed in integrating risk management considerations into an investment decision making process, but rolling out position-based analytics enhances a quantitative foundation of investment decision making.
“Additionally, if there are any discrepancies between how one manager is defining their exposures versus another manager, they are apt to be resolved in the course of risk aggregation as each portfolio is normalised prior to the upload. The fact that positions are provided to Imagine directly by respective administrators of underlying funds helps ensure accuracy. This benefits our clients because we’ve been able to create enhanced reporting capabilities,” says Segal.
Transparency is also a key part of the risk management framework for managed account platforms. “Having full segregation and control of the assets is necessary to mitigate operational risk,” says Stefan Keller, Head of MAP Research & External Relations at Lyxor. “We set pre-defined trading limits and then put an investment agreement in place to enforce those limits. We then use a number of independent administrators to provide valuations on the assets.”
Lyxor uses eight individual parameters for monitoring its managers: the instruments being traded; leverage levels; liquidity terms; Forex; sensitivity to market parameters; credit risk; concentration risk, and country risk.
“These are pre-defined parameters and then on an on-going basis the risk management process involves using stress tests, counterparty risk checks etc. We continue to evolve the risk infrastructure. The latest innovation is to introduce a “Follow-the-Sun” framework for valuation and risk monitoring,” adds Keller.
The way traders and portfolio managers view risk varies enormously. One of the more fascinating aspects to risk management is how behaviourial biases impact on their relative success.
In a recent paper entitled “Fear, overconfidence and irrationality: overcoming the psychological traits that undermine the asset management industry”, Simon Savage, risk specialist at GLG Partners makes a number of observations on behavioural risk. Firstly, managers are typically reluctant to deviate from benchmarks (and are essentially running closet tracker funds) for fear of failure. Secondly, Savage argues that believing in your own talent constitutes a “self-improvement disincentive” and that rather than fostering self-esteem, lauding a manager’s talent has the opposite effect, creating an “entity view”.
What Savage is getting at is that fund management is a skill-based profession and as such traders need to hone their skills on a daily basis. Otherwise, behaviourial risk becomes an impediment to self-improvement.
“Loss aversion is the single biggest reason for failure in our industry and it’s amazing how deeply rooted in our psyche it is,” says Savage. What is clear is that managers have a much higher capacity for running losers than they do for running winners; this is what GLG is trying to eradicate by getting its portfolio managers to develop processes and checklists that enable them to build on their strengths and mitigate their weaknesses.
“Self-awareness is important. That means focusing not on the outcome but on the process. What factors make you like a stock and want to invest in it? Keep track of those factors and let’s look at the outcome based on win:loss ratios,” adds Savage.
In addition, GLG wants its traders to operate within a risk framework that neutralises systematic exposures. Savage explains: “If you think about a classic risk framework there’ll be a model that spits out an estimate on tracking error, risk parameters that tell your exposure to value factors, momentum factors etc. That feedback to a manager has the right intention of corralling their risk. However, in the ultimate objective of making a good investment decision, it could be completely misaligned.
“Inevitably, P&L takes over as the primary decision candidate. As soon as any hint of loss aversion creeps in you tip the balance towards cutting winners and running losers. And as soon as that happens, you’re baking failure into the cake.”
Segal says that part of the discipline of risk management is being able to forecast the potential impact of various stress scenarios, e.g. the LTCM hedge fund blow-up in 1998 which lost USD4.6billion.
“We want to assess the risk drivers, break them down into component parts i.e. currency impact, equity price impact etc, and seek to understand what our exposure is and what impact it could have on the portfolio.
“You have to look at risk holistically; not just risks to your underlying instruments but risks to your investors, risks to your asset base. It’s important to be able to drill down to the lowest common risk denominator as well as the aggregate risk profile.”
Manager risk is a unique challenge faced by fund-of-funds. At Harcourt, the Vontobel Diversified Alpha fund uses, says Melo, a three-layer risk framework. The first layer is at the inception stage when concentration limits are set on strategies and styles within the portfolio. Second involves the ongoing monitoring of managers where risk and performance issues are regularly discussed and analysed.
“Thirdly, we look at risk measures for each individual manager and aggregate them to ensure there’s not too much risk concentration in a given asset class or market geography, and that the VaR limits are not being exceeded,” explains Melo, adding that the risk budget, overall, is set at the strategy level (after which individual limits are applied to each manager).
“Strategy A, say CTAs, might have 50 per cent of the risk budget and so on. Each fund is allocated to the corresponding strategy risk bucket so it’s very straightforward to monitor these risks across the portfolio. We then set risk concentration limits for each fund within the overall portfolio. No one fund can exceed 10 per cent of the portfolio’s risk budget.”
Segal says that a comprehensive approach to monitoring managers is vital as they evolve their strategies – and by default their risk profiles – over time:
“If they evolve their strategy, is their risk framework scaled up appropriately before they take on additional risk? This is very important for us to keep on top of.”
Greater transparency means that managers are on the hook more than ever. Regulatory and investor reporting means that managers have to be on top of all facets of risk. If not they face incurring reputation risk.
“Enhanced transparency is conducive to making our dialogue with managers more inclusive. It helps to be able to verify the information, but trust remains an important component of every manager relationship,” adds Segal.
Concludes Terry: “We now have a risk framework that not only gives us more of a holistic view of risk management, but is also sustainable and scalable. We’ve made a deliberate decision to move away from a silo-based approach to risk management.”
Hedge funds have to continue taking risks to boost returns and justify their fees. Having this holistic view of risk management will likely separate the winners from the losers.