Digital Assets Report


Like this article?

Sign up to our free newsletter

Technology helps unravel risk management complexity

Related Topics

Hedge fund investors are taking a more measured approach to their allocation process. They want to understand the alpha proposition and the risk-weighted return profile of a manager but, as important as market risk is, they want assurances that operational risk is being demonstrably managed.

This is a big challenge for start-up fund managers: how do they get a robust infrastructure in place in a cost-efficient way and remain viable?
“The reality is if you’re a manager launching with USD5-10m it’s very hard to get a demonstrable infrastructure in place that ticks the box,” says Phillip Chapple of KB Associates, a London-based operational consulting firm that supports managers in addressing investor operational due diligence requirements.
“This year I’ve seen 87 potential start-ups and only four of them have been viable. They have to have a unique alpha proposition but they also need an operational infrastructure that gives investors comfort and is appropriate,” adds Chapple.
Even though the majority of new inflows into hedge funds now originate from institutional pension plans, endowments and SWFs, some investors are willing to take a calculated risk with start-ups that don’t yet have institutional-quality operations in place. The need for diversification is driving this because not all investors want exposure to the same names. But as Chapple points out: “These are more day one angel investors who expect some kind of (fee) compensation. They want confirmation that these managers understand the risks and have a plan to grow the business.”
Andrew Downes is the COO of New York-based Atreaus Capital LP, a global macro hedge fund that launched in May 2012. He says that despite being a relatively new fund the firm has seen the expectations of investors increase, adding that when they launched they tried to ensure that the infrastructure was as robust as possible. This was achieved by using a number of outsourced service providers to handle risk analytics and report generation.
“If you have risk limits and you need to monitor them and enforce them, not using an independent provider who manages the data, deals with exceptions, enriches the data and validates all the reports is challenging. Even if, as a smaller firm, you hire your own team, you’re never going to have the same resources as risk system specialists. That’s a worry because, if it is a small team, you never know if someone is going to get sick or move to another firm – it creates ‘key person risk’,” says Downes.
To illustrate how investors are pushing managers to up their game operationally speaking, Atreaus Capital recently selected SunGard’s Hedge360 risk reporting service to handle the creation of its daily customised risk reports for its risk management purposes; this is on top of a monthly risk report that gets disseminated to investors.
“What we found was that our previous provider has a menu of different reports but the daily report we wanted to produce for ourselves and the monthly report for our investors was not something they had a form for. We were doing a fair amount of manual work to produce the daily reports we wanted,” says Downes.
This led to Atreaus using SunGard’s APT risk system in parallel with Front Arena to meet the customisation demands and ultimately benefit from the automation power of the Hedge360 platform.
Atreaus is just one of numerous managers who now increasingly rely on outsourced service providers to get around the operational challenges that face the industry.
As the risk management challenges grow – especially as managers explore new market areas and trade new asset classes – what is reassuring is that technology innovation is keeping pace. Front office traders are now able to manage risk exposures in real time alongside the book, giving them far more powerful insights into how the strategy might be affected in periods of different market stress.
However, financial intermediaries – prime brokers, clearing firms, SMA platforms, multi-manager allocators – need just as much of a handle on market risk as their clients. Not only that, they need to do so at an aggregate level. New York-based Liquid Holdings has just released a solution that provides a single real time risk management window across a firm’s entire trading counterparties. Known as LiquidFIRM (Financial Intermediary Risk Management), it provides myriad post-trade risk controls that boutique primes, for example, have never been able to use before because of cost constraints.
“You may have one client that doesn’t have a concentrated position but if you look across all 50 clients, maybe you as a firm do. LiquidFIRM supports that ability to make more informed investment decisions,” says Robert O’Boyle, Liquid’s Executive Vice President and Director of Sales & Marketing.
In effect it acts as an early warning system by giving the intermediary a heads-up – which is achieved through the generation of an exceptions report – so that a potential risk management issue (e.g. a customer is about to get hit by a margin call) can be nipped in the bud. This is good news for smaller prime brokers because the last thing clearing firms want to do is have to deal with problem clients.
“It helps if managers themselves use LiquidFIRM in-house as well to monitor their risk real time. If they fall outside the risk parameters (agreed with their prime broker) it gives the manager the ability to alleviate the problem before the markets close,” adds O’Boyle.
Using LiquidFIRM, a client can quickly generate an exceptions report to see which accounts, if any, have violated any of the pre-defined risk parameters.
“What this means is that you don’t have to drill down into all your clients to check that everything’s okay. If there is an issue, you can drill down into the account to see what the problem is. The power of LiquidFIRM is that because it can handle so much data for so many different accounts you don’t have to keep looking at every underlying account all day long. The exceptions report tells you exactly where to go and look,” explains O’Boyle.
One of the biggest risk management challenges for hedge funders is dealing with the deluge of regulation that has fallen into the market over the last few years. It’s a massive burden and one that no manager can ill afford to get wrong.
Downes confirms that one of the more significant burdens post-launch has been the increasing regulatory reporting obligations. “We were SEC registered on day one, then the CFTC rules changed and we became a registered CPO so we are having to do Form PF filings annually and CPO-PQR filings on a quarterly basis. In the UK we will continue to rely on the private placement regime as a non-EU AIFM marketing a non-EU AIF under the AIFMD which will involve additional reporting obligations. Although less of a burden than for an EU AIFM that is marketing an EU AIF, it’s a burden nevertheless.”
Atreaus Capital is even preparing for regulation that has yet to happen. As a global macro manager, it trades a lot of FX contracts. At some point, regulation will requires the clearing of non-deliverable forward (NDF) contracts, following in the footsteps of OTC swaps.
“In order to clear FX NDFs you will need to be connected to a middleware provider that connects traders, brokers, clearers and the clearing houses. One of these firms is Traiana. What’s good about Traiana is that, in addition to connectivity for clearing, it will effectively help us automate a lot of the reconciliation processes post-trade. We plan to start using it later this year. That automation will give us even more redundancy in our operations and make us more efficient. It’s a useful labour saving solution,” says Downes. 
Chapple stresses that for any new hedge fund it has become a necessity to have a non-trading member of the team to act as the COO – which is typically the biggest cost.
“Investors want to see that someone away from the trading desk is monitoring reconciliations, looking at compliance, managing counterparties on a daily basis. I find the most dangerous situation is where people outsource everything to a third party administrator and don’t realise that they still need to provide oversight on the appointed service provider(s). The first barrier (to achieving a solid infrastructure) is having this independent COO in place. The second is the administrator – who it is, what services are they providing? How are you looking at confirmations and fills when trading? You need that level of control in place.”
Such is the barrier to entry for new talent that some are turning to platforms rather than launch standalone funds.
Under AIFMD this could have unintended consequences. As Chapple explains: “A small manager with EUR10mn might choose to join a regulatory umbrella (which acts as the third party AIFM) but if the aggregate AuM of the platform exceeds EUR100mn (including leverage) the manager will inadvertently become a full scope manager under the directive and be required to appoint a depositary; an unnecessary cost that they could have avoided as a de minimis manager.
“That’s something we’ve only seen the effect of recently. It’s a strange situation because if the manager had waited and received their own FCA authorisation they’d fall out of the scope of AIFMD.”
This is where firms like KB Associates can help managers by raising these issues and guiding managers towards making the best operational decisions.
One area of risk management, however, that still remains the most enigmatic is that of behavioural risk. No matter how exceptional the operational infrastructure or how robust the risk analytics framework, if traders and portfolio managers are not willing to address their behavioural biases then it counts for nothing.
“It is quite frightening how ignorant many participants are of these biases even though they operate in a profession that is purely linked to mental decision making. Traders and fund manager know intuitively that they make different decisions depending on whether they are making or losing money but maybe don’t know what to do about it. Engaging in an activity without really understanding the mechanics makes me believe that behavioural risk is one of the most significant risks,” says Simon Savage, Risk Specialist at Man GLG.
Whilst it is impossible to rewire the human brain, by coaching managers to make them better aware of the impact these biases have on their trading performance it is possible to bring about incremental gains; which, just as in elite sport, can lead to a significant overall improvement.
“If a trader is conscious that they might be vulnerable to certain biases they are better able to put in place logic traps and that’s something we encourage our managers to think about; take time with decisions. Build a way to slow down your decision making. Get second or third opinions from colleagues to inhibit the reflex-type response to trading,” adds Savage.
Key to this is providing the front office with regular feedback. They need to see the data to appreciate the impacts that behavioural biases have on their trading profile. What did the returns look like prior to closing a profitable trade (day zero) and for a period afterwards? When compared to losing positions, a manager’s capacity for loss aversion is an order of magnitude lower; we are far less willing to admit to losses and wait as long as possible in the hope that things will rebound. This is the classic bias of running with the losers but cutting the winners.
It is, as Savage says, a “fear of crystallising the loss”.
“One of the main bits of feedback is understanding what different managers’ core strengths are and the market environments in which their strengths work or don’t work. We have one short-term trader who follows a simple KPI, which is basically a time stop-loss. He knows that if a position gets too old he has to cut it. His sweet spot is running positions for one or two weeks so if he has a position that’s three weeks old, whatever the price he closes it.”
There’s no silver bullet to overcoming behavioural risk just as there’s no single solution to being completely immune to operational risk. Awareness and a willingness to address the issue, in both instances, can a long way to building incremental gains. Something that any investor will look upon favourably. 

Like this article? Sign up to our free newsletter

Most Popular

Further Reading