Risk management trends and developments: what are leading asset managers and investors now doing?

April 2017  |  SPECIAL REPORT: MANAGING RISK

Financier Worldwide Magazine

April 2017 Issue

April 2017 Issue


In the proverbial ‘beginning’, formal risk management – which entails not only measurement and reporting of risks, but, also, prudent management and governance of risks – was primarily only practiced by a select number of large global investment banks, such as JP Morgan, Goldman and Citi. It is not hard to understand why these types of financial institutions, which are highly regulated and routinely take tremendous amounts of balance sheet risk, as well as market and credit risks, would be doing sophisticated and comprehensive risk management.

How, then, did the practice of risk management proliferate from a few behemoth financial institutions into a growing trend, whereby many types of institutions, both large and small, are either beginning to consider or are now doing more formal risk management? Part of the answer to this question lies in the 2008 financial crisis, a crisis unlike any other cyclical crisis that investors had previously witnessed. The sheer magnitude and global scope made this crisis different; in fact, it was the worst financial crisis the world has seen in the modern era. As a result, it inexorably changed people’s perceptions and attitudes about the remoteness of potential risks and the merit in preparing for risk outcomes – even those risks that otherwise might be deemed outlier or ‘tail risk’ events.

Essentially, the 2008 financial crisis was a major precipitating factor for the ‘big bang’ that caused a number of institutions, whether asset managers or institutional investors, to begin to seriously focus on risk management. In the aftermath of the crisis, both sweeping regulatory and secular changes began to support the acceleration of this trend. Consequently, a large number of institutions were either forced into, or, in some cases, voluntarily started doing more, formal risk management. For example, risk management reporting requirements, such as Form PF, AIFMD/Annex IV and, most recently, Form N-PORT, were all borne out of regulatory concerns about assessing and monitoring systemic risk in the financial system. At a minimum, the need to comply with these new regulations forced many fund managers to begin to implement some basic levels of risk measurement and reporting that they may not otherwise have begun.

On the investor side, because many investors suffered substantial investment losses after the financial crisis, most of the larger institutional investors that comprise the universe of pensions, endowments and foundations have significantly enhanced their due diligence scrutiny of and their requirements for risk management. Fund managers are more cognizant of the fact that investors have upped their game with regard to risk management and, in order to attract and retain these investors, smarter fund managers have not only improved what they do for risk management to satisfy investors but, also, now see risk management as a means to produce enhanced and more repeatable risk-adjusted returns.

What are leading asset managers and institutional investors now doing?

In terms of risk management trends, among leading asset managers that are already doing some basic risk management, such as risk measurement and risk reporting, we have observed a strong interest in making their risk management more actionable. Specifically, we see that more sophisticated asset managers have come to the realisation that risk management cannot be actionable until there are well-defined risk management processes, controls and governance fully in place. For example, generally, most asset managers that have well-functioning risk management now have a risk management committee to oversee the execution of the firm’s risk management policies and procedures and to ensure that the fund’s risk management is effective.

We are finding that some fund managers that are looking to further advance what they do for risk management are trying to improve and optimise their process for the allocation of risk across different fund strategies, portfolio managers and geographic regions. In addition, we have seen firms that are actively seeking ways to make their risk management impactful by hedging their potential downside risks through hedging and risk overlays. Furthermore, the fund managers with the most superior risk management capabilities are now using risk management as the basis to develop a risk-based compensation framework that rewards their portfolio managers and analysts on their ability to produce solid long-term risk-adjusted performance for the firm and its funds.

For some of the newcomers to risk management within the asset management industry, such as private equity (PE) firms, we are seeing efforts to improve their transparency around risk management to their investors and, given the increased scrutiny they face from regulators and investors, a subset number of these firms are focusing on improving their valuation process and metrics. Meanwhile, we are finding that the more sophisticated PE firms are looking for ways to improve their risk management screening of prospective portfolio companies by doing more than simply calculating discounted cash-flows on an Excel spreadsheet. Rather, they are looking for improved ways to better execute and monitor key strategic, financial and operational milestones with the goal of improving their likelihood of a successful exit for their portfolio companies.

For institutional investors, the most significant trend we have observed is that many more institutions now realise that their investment consultant does not provide them with any assistance with regard to investment risk management; and that there is an inherent conflict of interest in their doing so, given the investment consultant’s role in advising their clients on asset allocation and manager selection.

Among institutional investors, such as pensions, endowments and foundations, another notable trend is that some of these institutions realise that their investment policy statement (IPS) either does not address risk management at all or is extremely vague on the matter. Therefore, we are seeing a slow but growing trend among institutional investors of developing risk policy guidelines as a companion piece or as an addendum to their IPS. These guidelines are intended for an institution to lay out its specific risk management parameters for investment risks, such as maximum drawdown, liquidity risk, and concentration risk and portfolio volatility. These guidelines are crucial for an institutional investor to have clear risk management boundaries that not only serve as a basis for monitoring investment risks, but also to ensure that any asset allocation changes – strategic or tactical – are in line with an institution’s budget for risk.

We see a growing interest from institutional investors that are beginning to realise the need for having risk management and performance attribution and benchmark reporting, not only to do a better job of monitoring and managing their investment risks but also to minimise their fiduciary risks. At this time, only a small number of very large and sophisticated institutional investors have the internal capabilities to do such complex risk measurement, risk monitoring and risk reporting. However, over time, midsize and smaller institutional investors will likely possess similar risk measurement and reporting capabilities, but with the assistance of independent risk management firms that have the experience and capabilities to provide this advanced analysis and reporting as an outsourced and managed service to them.

‘Make’ versus ‘buy’

As risk management has become more prevalent, we have found that firms with a longer history of practicing formal risk management are not only increasingly interested in ways to improve what they do for risk management, but, also, in ways to make their risk management function more efficient, cost effective and impactful.

On the issue of cost, firms are interested in the classic comparison of ‘make versus buy’ in deciding whether they should do some or all of their risk management function internally or utilise an external third-party adviser and provider. The correct decision as to which route to go is not always clear cut, and an asset manager or institutional investor must define their risk management goals and do an honest assessment of whether the institution has the necessary internal resources – staffing, risk systems and other key infrastructure – to perform the risk management function on its own in a sound and effective manner.

Recommendations

There are two notable areas in particular where we believe it makes the most sense to utilise an external and expert third-party adviser and provider for risk management. First, for the risk measurement, risk monitoring and risk reporting functions, a fund or institutional investor may be substantially better off, from both a cost and effectiveness perspective, working with a risk management advisory firm that has complete and cost effective managed services for this aspect of risk management. In this case, the advantages of an outsourced solution may include saving the cost of an annual software licence for a risk software system, having reduced or no fees for market data feeds for the risk system, and saving significant costs associated with having an internal risk management staff to implement and maintain the risk measurement and reporting infrastructure and processes.

A second area an asset manager or institutional investor would be wise to consider using an independent and expert third-party risk management provider is with regard to performing any reviews or assessments of an institution’s objectives for risk management, its risk management policies and procedures, internal capabilities to do risk management or in determining whether an institution’s risk management programme is well-functioning. Akin to the way that a financial auditor is today universally used to review, audit and validate an institution’s financial statements, it would be strongly advisable and prudent for asset managers and institutional investors to work with an experienced and qualified risk management firm to periodically review and validate that their respective risk management practices are appropriate, sound and effective.

 

Samuel K. Won is the founder and managing director of Global Risk Management Advisors, Inc. He can be contacted on +1 (212) 230 1610 or by email: swon@grmainc.com.

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