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How can managers make risk more strategic?

In a post-regulatory world, one of the ways for hedge fund managers to gain an edge on their peers is thinking about how to make risk more strategic. To tell a more coherent story, in terms of how they manage risk to improve their reputation and their asset raising capabilities, as well as helping with the overall performance of their fund(s). 

This needn’t be confined purely to investment risk. As will be revealed, it could also include technology risk and liquidity risk, to name but two. 

Providing tools for managers to move risk management into the front-office to gain clearer insights into how ex ante risk can be measured and analysed at the pre-trade level, when building positions in portfolios, is becoming more popular. Hedge funds understand that active risk management can be a key component of a fund’s performance, not something to stymie the portfolio manager. 

“Asset owners are pressing hedge fund managers on the total cost of ownership and making sure there is a real value proposition being offered. Our clients want to be able to prove this using our risk analytics and performance analytics, and demonstrate that they have a compelling story to tell,” says Ian Webster, Chief Operating Officer at Axioma, whose Axioma Portfolio solution can best be thought of as the front office tool for portfolio construction. 

There are three categories of fund managers, when it comes to risk. 

Category one is basic risk reporters. The regulators and investors want a risk number to attach to the fund so they provide the basic risk report. They see it as a necessary evil. Category two includes those who are trying to control risk; they may have dedicated risk departments who construct risk overlays to hedge risk within portfolios. Category three includes those whereby risk is an integral part of their portfolio management construction process. 

“If you embed risk management as part of your investment process, you don’t treat it merely as a hedging overlay, you don’t treat it merely as a reporting function, you make the portfolio manager responsible for that risk.

“That immediately gives you a much more robust way of managing portfolios. And I think there’s an argument that suggests, ultimately, if the portfolio manager is responsible for the risks being taken, you get 1) a much more controlled environment, and 2) potentially an environment where trading becomes more cost efficient. The more you have to overlay, and put extra controls around the portfolio manager, the more you introduce additional costs,” explains Webster. 

In his view, as the portfolio manager is ultimately responsible for the fund’s returns, they ought to take responsibility for the risk as well. “You shouldn’t be sub-contracting that risk to another department or individual within the firm,” he adds.

Treating market risk more strategically and embedding it into the investment process, makes for a much more compelling marketing pitch. 

Axioma Risk is a leading solution for firms to analyse their portfolios once they’ve been constructed using Axioma Portfolio. Rather than view market risk in a monolithic fashion, Axioma Risk helps managers to develop a more three-dimensional picture. 

Webster says that there are three key areas one should be thinking about. The first is the portfolio construction process, taking into account your risk budget and risk appetite. The second part is portfolio analysis, of which risk analysis is a part: really understanding what is happening within the portfolio. 

“We have many different models that clients can run so analysis is a key component. And thirdly, scenario analysis – stress testing, running `What ifº’ scenarios to look across the portfolio to see what might happen in the future, if certain market conditions were to prevail. 

“Just as risk overall, has many components, so within market risk itself there are many tools one can use to understand the risks you are holding within your portfolio. The smarter fund managers in the industry are not using a single tool, they are looking at investment risk through multiple lenses: from a factor risk management perspective, a granular risk management perspective, using statistical models, scenario analysis and so on,” says Webster.

Ittai Korin is President, PortfolioScience. He observes that integrating risk management more into the front-office has been a significant trend in the post-regulatory environment. 

“To the extent that things are easily and more dynamically accessible and integrated, it means that risk can show up in more places than it used to. For example, in the front-office, PortfolioScience RiskAPI can be used alongside a firm’s portfolio management system. All of a sudden, there is a much wider spectrum of risk data points going into the decision-making process in the front-office. Rather than looking at things once a month or once a quarter, the portfolio management team can look at where they are trading, in real time, and make more quantitative risk management decisions,” says Korin.

Depending on a fund’s mandate and workflow, in many cases, he says, the introduction of risk into the portfolio allocation process was entirely dependent on the individual mandate. Funds that were purely fundamental, or quant-focused, would say, `We’re not interested in risk being part of the decision making process’. 

“In today’s regulatory climate, it’s no longer possible to take that approach. Just because you are a fundamental fund, for example, doesn’t mean you shouldn’t be looking at risk data points in running the strategy,” adds Korin. 

In that respect, technology is substantially enhancing the way that investment risk is managed, not just at the pre-trade compliance level, but post-trade as well. In other words, risk management has become as much a forward-looking (ex ante) process, as a backward-looking (ex post) process. Larger, sophisticated managers have been doing this for years. The difference today is that with regulation such as AIFMD, all managers, even those running modest AUMs, have had to bring risk management into much closer strategic alliance with portfolio management. 

This in turn has the potential to give fund managers greater confidence in broadening the strategy suite. They may spot an opportunity of attracting niche investors by offering a regulated version of their flagship strategy. In order to do so, however, they have to be certain that they can monitor risk limits and stay within regulatory guidelines. 

“Let’s say a portfolio manager is executing on their strategy and they don’t realise that by buying certain instruments it would significantly increase the VaR of the portfolio and exceed the monetary threshold,” comments Raya Gabry, Associate Director, Product Management at Eze Software. “When a portfolio manager is executing an investment strategy, they aren’t necessarily thinking about regulatory or firm-level restrictions. This can be overcome using RiskAPI in conjunction with Eze Compliance. Even if you’re not keeping these things in mind while running the strategy, you have to still ensure that no limits or rules are breached at the pre-trade level.”

One of the unintended consequences of market regulation is that it has, inadvertently or not, required fund managers to gain much greater transparency into another aspect of their trading environment: liquidity risk. 

With the upcoming SEC Rule 22e-4, both the buy-side and sell-side will need to apportion assets into four liquidity buckets so as to have a clear estimation of their liquidity distribution over a certain time horizon. 

Bloomberg has a solution to manage this risk exercise, known as Bloomberg LQA. ‘

As Naz Quadri, Head of Liquidity Analytics for Bloomberg’s Enterprise Solutions business explains, it works in three different ways to help clients: a single security mode, a portfolio mode and an offline batch processing mode: “What we are solving, at the root level, is to give clients the ability to answer the following questions: `First, if I hold a certain amount of a given security how long will it take me to get out of my position with minimal market impact? Second, if I must liquidate a percentage of my holdings in a certain number of days, what cost impact would that have?’

“LQA uses a fully probabilistic model that allows users to ask questions with a 90% confidence outcome, a 70% confidence outcome; whatever is acceptable.”

Bloomberg’s LQA can also be applied at the portfolio level. A solution called LQAP allows users to load a portfolio and run bucketing scenarios under various market conditions.

“Under rule 22e-4, the SEC gives investment advisers flexibility in terms of doing what is necessary without significantly changing the market value, what are foreseeably stressed market conditions, and what they feel is a reasonably anticipated trading size. All of these are various inputs that can be entered into LQAP and out will come a distribution,” says Quadri.

He adds that regulations such as rule 22e-4 mean that managers’ trading and execution workflows should take into consideration these new liquidity regulations. Previously, portfolio managers made investment decisions without necessarily thinking about how the fund’s liquidity profile would change.

“Now, they need to see at the pre-trade stage what the liquidity impact will be on the fund otherwise they might have to take corrective measures. So it will make liquidity risk management more of an ex ante function,” confirms Quadri.

One other aspect of the risk function that could help managers become more strategic is by simply establishing a technology risk management process. This needn’t be arduous at all. By identifying every IT risk in the business, and building a process that prioritises those risks, and what mitigating actions need to be taken, the manager can straightaway gain greater clarity on where to spend their IT budget.

“If an investor visits a fund manager to do their ODD and asks what their largest technology risk is, the manager should be able to pull out a spreadsheet and tell that investor what their top five risks are. And not only that, they can tell them, in detail, what they are doing to mitigate those risks. That’s going to give investors a lot more confidence,” asserts George Ralph, Managing Director of RFA, one of the industry’s leading IT advisory groups. 

He adds: “Fund managers want to proactively look at what mitigating actions can be taken against the risks and the sentiment is, `If we just invest in X or Y based on RFA’s input, we can dramatically take our risk level down’.” 

Whether it is market risk, liquidity risk or technology risk, the common thread of this argument is that by approaching things from a position of knowledge, fund managers will be better equipped to make smarter, more strategic risk management decisions. 

That can count significantly in one’s favour, when trying to stand out from the crowd.

“Investors want to know what you’re doing to mitigate your risks from an operational perspective. Even more importantly, they want evidence that you know what your risks are. The worst case scenario is an investor asking a manager, `What are you doing to manage your IT risk’ and the response is, `Oh, nothing. We outsource it all.’ You can outsource technology but you can’t outsource risk,” concludes Ralph. 

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