Group Co.
The Economic Cost of "Good Enough" Risk Management for Asset Owners
Traders Magazine Online News, January 24, 2019
One of the industry trends that is impacting both asset managers and asset owners is that several vendors are beginning to offer "all in one" centralized computer systems that are intended to support all functions of an investment institution including decision making ("front office"), trading ("middle office") and operations ("back office"). The argument for these all in one systems is that there are material operating cost savings associated with consolidating many independent systems. On the other hand, several clients have expressed the view that while these systems may offer "good enough" functionality in areas such as risk assessment or transaction cost assessment, they are uncomfortable making decisions on what they believe is less than the best available analysis.
It can be clearly demonstrated that in most cases, any reduction in the perceived accuracy of risk assessment for a large asset owner will vastly outweigh the economic benefit of the cost savings. A simple example should be sufficient to illustrate the point. Let us consider the case of a hypothetical asset owner called Pension X, which has $30 Billion in assets of which 50% are invested in illiquid assets (which are problematic for most risk systems). Pension X currently spends $120,000 per annum for a risk system but believes they can save $25 million per annum in operating costs by consolidating on an "all in one" system. We will use very typical capital market expectations that the expected rate of return on their portfolio is 7% (arithmetic average) with an annual expected volatility of 10%.
Assuming a fixed level of expenses, the expectation of the percentage geometric mean rate of return is 6.5% (7 - 102/200) [see Messmore (1995)]. The current spending of on risk assessment in dollars is 1.2 * 105 which as a percentage of the fund is 4 * 10-4. If these costs were removed, the expectation of the geometric mean return would increase to 6.5004%. This doesn't seem very significant but saving $120,000 per annum certainly sounds appealing as compared to not doing so.
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