The Evolving Role of Risk in Fund Management

The rolling and possibly on-going financial crisis that started in 2007 has provided risk managers with an invaluable learning experience. Irrespective of the claims of individual fund managers, the industry as a whole performed poorly, and it is as a reflection of this reality, that the evolution of risk management should be understood. There are currently three major drivers of the evolution of risk in fund management – regulatory pressure, investor pressure and, perhaps surprisingly, big data; and it is in the interaction of these forces that one can observe both the current state and likely path of risk in fund management.
Regulatory pressure has been, and is most likely to continue to be the most important driver in the evolution of risk in fund management. The Alternative Investment Fund Managers Directive (AIFMD 2011/16/EU) has profound implications for the role of the risk manager in an investment fund. On a personal level, their independence, as required by AIFMD effectively removes the risk managers from the performance pool of the fund. With respect to their relevance in the corporate structure, the risk function must have at least equivalent status with the investment function on the board of the fund. And finally with respect to the job specification, they are required, at the very least, to identify, measure, monitor and manage all market, counterparty, credit and liquidity risks, both now and in the future and to carry out stress and scenario test on all of the above on an ongoing basis.
What is remarkable about this legislative overhaul of risk management is that it is most likely current best practise anyway for large asset managers. The profound difference of AIFMD is the intention to apply such obligations to managers with funds in the hundreds of millions rather than the tens of billions. This is reinforced by the Annex IV reporting requirements that demand managers give a detailed breakdown of their risk (over 250 separate line items) on a quarterly basis. It is also worth noting that it is somewhat anomalous that under AIFMD, alternative investment funds seems to be operating in a stricter regime that their notionally less risky UCITS (Undertakings for Collective Investment in Transferable Securities) cousins. The regulators are not unaware of this anomaly and it seems likely that an enhanced risk management requirement will be a feature of any future UCITS legislation. Lastly regulators are becoming increasingly concerned about lax compliance with existing regulations. Fines due to breaches are indicative of a lack of tolerance for those attempting, consciously or not, to avoid their regulatory requirements.
The second major driver of the evolution of risk management has been investor pressure. Firstly there has been a demand for increased transparency with increased frequency of reporting on the risks that the fund is taking. Whilst one solution to this demand is to set up managed accounts, in the event that this is neither possible nor desirable, the risk management function may be expanded to cater for these extra demands. These demands relate not only to market risk but also to counterparty risk and the investors aggregate exposure over all their investments. In addition, and in line with the specific requirements of the AIFMD, investors are starting to tailor their investment size with the liquidity profile, both market and investor, of the invested fund.
Investor pressure is observable in the decreasing tolerance for breaches in the fund’s investment mandate. Whilst previously, it was possible for breaches to be resolved over a significant period of time, that tolerance has significantly diminished. A strict requirement to be compliant by close of business is not an uncommon feature in funds launched today. As noted above, the regulators are taking an increasingly dimmer view of any breaches, but at the same time investors are requiring assurances that their funds are being managed in a manner consistent with their mandate on an ongoing basis. This is leading to an increase in both the scope and the responsibilities of risk managers within an investment fund.
It is in combination with the two drivers mentioned above, that “Big Data” which we will explain in more detail below, is having a significant impact on the evolution of risk in fund management. Historically the role of the risk manager has been to be the person to take the flak when “bad things” happen. This was a role generally without proper responsibility, insofar as the risk function typically reported to the Chief Investment Officer, and without proper tools, the actual risk analysis was generally carried out in a spreadsheet. Whilst spreadsheets are valuable for many analysis tasks they are wholly unsuitable for financial risk analysis. The responsibility issue has been largely mitigated with the demand for a truly independent risk function and it is in the use of “Big Data” that the tools issue is being solved. By “Big Data” I am referring to the integration of functionality that has previously been very separate.
Firstly, indicative and time series data, which was previously unavailable, then only available on Bloomberg can now be accessed from a wide number of sources. Secondly, cloud based (remote from user site) servers and databases with advanced processing power gives users the ability to run calculations in seconds that previously would have taken hours. Lastly, web interfaces allow the results of these analyses to be observed by a wide range of users, from traders, to investment committees to the Board of Directors. In addition investor transparency may also be enhanced using these web based techniques. It should also be noted that the Annex IV reporting as discussed above requires that the reported data be delivered in the form of an XML file, illustrating the regulators envisage a significant upgrade in the risk analysis capabilities of a funds risk management function.
Regulatory and investor pressure have greatly expanded the role of risk in fund management. However it is the use of “Big Data” that means that it has a greatly enhanced the ability to carry out that role effectively. Excessive amounts of time were previously spent either as a “data rat”, attempting to get the indicative data necessary to carry out an analysis or as a position manager, attempting to reconcile trader blotters with back office reports. This generally left little time for the more relevant tasks of a risk manager – the monitoring of ongoing risk and the identification of risk mitigation strategies in the event of their being needed. Remote, secure and fast functionality allow the risk manager to dispense with a significant part of the drudgery of their role: that which can be done by computers, should be done by computers, whilst at the same time giving them the tools to better understand the risks of the funds for which they are responsible.
To conclude, the role of the risk manager has evolved far and fast in the past five years. From a partially ineffective bystander, the risk manager now has both the regulatory imposed powers and the cloud based tools to effectively monitor and if necessary limit the financial risk of a fund. It seems likely that such powers and tools are likely to be enhanced in the next few years. Except for the megalomaniacal risk manager, this prospect may be viewed with some trepidation by other stakeholders in the fund management business, particularly investors. Increased power to limit risk should limit potential downsides but it will definitely limit returns. That said if you avoid a severe drawdown i.e. a permanent loss of capital, your long term returns may actually be better – experience a severe drawdown and you may be out of business. In addition it is axiomatic that fund management and risk management are intimately related. Care must be taken to ensure that whilst the risk function is independent, risk management remains an essential element of the investment process.