Risk Management For Investment Funds
Claire Spencer, March 2010
It may have been a secondary concern during the M&A boom, but today, effective risk management is more important that it has ever been. Investors who saw the value of their investments plummet when the financial crisis broke are insisting that the funds they invest with have an efficient and comprehensive risk management framework in place. But not all fund managers have reacted as quickly as they might, and their inaction may limit their appeal.
The risk remains
One legacy left to investment funds by the financial crisis was greater knowledge of the nature of risk, particularly in the form of fraud or counterparty risk. As a consequence, fund managers are (or at least should be) well-versed in the benefits of a frank and thorough approach to risk. “Implementing an effective risk management program protects both investors and fund managers,” asserts Marie DeFalco, a partner and vice chair of the Investment Management Group at Lowenstein Sandler. “It can protect investor assets from potential losses due to rogue trading or other employee fraud risks, counterparty risks, and the manager’s inherent business model risks, among others. It can also protect the management firm from the reputational damage associated with lapses in oversight, regulatory disciplinary action, and the potential massive redemptions and even business collapse that can result from ineffective procedures or implementation,” she explains.
Many investors took a direct hit from a combination of decreasing asset values and the after effects of their deficient due diligence and monitoring practices concerning fund managers. Economic conditions may be improving, but investors are much more attuned to risk and demand higher standards from the funds in which they invest. Investors recognise that if their own risk management is efficient and comprehensive, it should ensure that they have the means to assess risk across their entire investment portfolio and that funds are performing as expected. For fund managers, the effects are more direct, explains Gerhard Niggli, a partner at Niggli Rechtsanwälte. “The compensation of fund managers is based on the assets of the fund. Accordingly, fund managers have a strong interest to preserve the assets in the fund – particularly since the acquisition of new investors is enormously expensive. An effective risk management framework will help to align expectations of investors with the performance of a fund, and the adoption of a fund’s profile to the changing environment,” he says. Further, it will assist a fund to comply with regulatory requirements.
Benefits aside, the most compelling reason for fund managers to strengthen their risk management regime is to satisfy investor demand. “Virtually every fund manager has experienced increased demand for risk management from investors, with fund-of-fund managers probably targeted most heavily in recent memory, primarily as result of the headlines surrounding the Bernie Madoff scandal,” notes Ms DeFalco. “At this point, the requirements are primarily market-driven, notwithstanding the increased attention of regulators and legislators and both comprehensive and targeted proposed reforms and increased regulation. This is most evident in the increased demand for transparency and risk monitoring provided by managed accounts and managed account platforms,” she says. Of course, the general attitude to risk may shift if asset prices rise once more, and if proposed legislative reforms come into force. However, Ms DeFalco warns that regulation is often misdirected and ineffective with respect to certain risks, such as outright fraud, and lagging with respect to others.
It has certainly been a turbulent period for investment funds. Take, for example, Swiss regulated funds of hedge funds. Most have been languishing, some forced to wind down due to record redemption requests and receding liquidity levels at underlying funds. These funds severely underestimated, or even completely ignored, their liquidity risk portfolios. As a consequence of this activity, Swiss regulators have stopped approving new retail fund of hedge funds, and are keeping a much closer eye on those that remain, thereby driving the demand for comprehensive risk management. However, it is notable that, in spite of their losses, the risk management systems at these particular types of fund have been subject to relatively little change. This was also the case with so-called absolute return funds established during the boom years – they claimed that, irrespective of the economic environment, they would perform. Of course, this proved to be untrue, again showing that the risks arising from their complex investment strategies and instruments have been either underestimated or ignored. Now, both investors and the authorities have called for managers of these funds to focus on the risk embedded in complex financial products.
In the offshore fund sector, however, there have been two distinct developments, according to Mr Niggli. “Institutional investors have become much more demanding on the risk management frameworks of fund managers and request a high degree of transparency, as do the fund’s prime brokers and leverage providers. In the context of offshore fund investments by private banking clients, there has been pressure on banks to improve or implement risk management in the fund selection process. Private banking clients have suffered substantial losses from investments in Madoff feeder funds, and some banks have been forced to buy out their clients, since the fund investments were unsuitable for their clients’ needs and they had performed only minimal due diligence on the feeder funds,” he explains. In general, it is thought that the regulatory reaction will focus on the selection and risk management process of intermediaries and on the selection of the funds they place with or recommend to their clients. In particular, the procedures for assessing the suitability of a certain fund for a particular client will be scrutinised.
Practical measures
If fund managers are not committed to creating and implementing a risk management program, they will be at a disadvantage in their market. They need to foster an environment in which concerns about risk can be expressed, logged and tackled in a systemic manner. Such programmes need to be integrated into an existing organisation, and should be a key part of portfolio management. Of course, risk management is not an isolated organisational process; there is a need for complementary regulation, for external controls and checks to help stabilise the market. Nonetheless, risks can be considered in two broad groups: investment risks – such as those associated with volatility, leverage, concentration, style drift, liquidity, geographical, geopolitical, currency and valuation – and operational risks – such as those associated with conflicts of interest, counterparty, fraud and business model. Investment risk has been the main concern and this is likely to continue, notes Mr Niggli. “Aside from this, funds should particularly focus on certain high-risk areas. For example, regulated funds have essentially ignored credit risks arising from their counterparties. This has dramatically changed with the collapse of Bear Stearns and Lehman Brothers, and the need for governmental support by a substantial number of system-relevant banks. The old saying that one does not have really to care about counterparty risk with respect to the brand name international banks, since the end of one bank would be the end of the system, has proved to be wrong,” he says. Now, counterparty risks arising from sub-custody arrangements, securities lending arrangements, cash deposits etc., are finally a focus.
Liquidity risk has also largely been ignored by regulated funds. The drain of liquidity away from hedge funds and the resulting difficulties faced by fund of hedge funds have demonstrated this fact. Homogeneity of the investment base is a particularly big problem, as simultaneous redemptions are more likely in these circumstances. In such cases, funds need to implement mechanisms such as holding technical liquidity, increasing credit lines and establishing notice periods to protect investors from losses. Whether this will become common practice remains to be seen. Although fund managers are not openly disputing the benefits of effective risk management, this does not necessarily equate to actual implementation. “There are generally small or start-up managers that are not prepared to implement a comprehensive and effective program. As alternative investments become more and more institutionalised, and particularly if they become more highly regulated, the practical barriers to entry increase. Anyone trying to launch a fund without adequate capitalisation should understand that a fund will not be able to attract quality investors and, worse still, the firm will expose itself to potentially devastating liabilities by skimping on oversight. Fortunately, if a firm is committed to effective risk management but merely lacks the internal staff, there are excellent service providers in the field available to help,” notes Ms DeFalco. Some fund managers can be reticent to disclose their risk management frameworks to potential investors, partly due to the integration of the risk framework into the general risk management process, which is generally kept under wraps – although others are the opposite, keen to show off the robustness of their risk management.
Nonetheless, as the alternative investment industry becomes more institutionalised, the focus on risk management will become even more intense. Investors are continuing to conduct more due diligence on fund managers, and further, are demanding far more transparency. Ultimately, higher and more consistent standards of risk management have the potential to be a good thing for the industry. A portion of those funds that choose not to adapt are likely to succumb to one or more of the myriad risks they face, while those that remain increase their vigilance and create a stronger industry in the long term.
