De-risky Business: A Tale of Two Funds

Integrated risk tools are the cornerstone for better trading decisions inside hedge funds.

Rewinding back in time to 2011, one of the 20 largest European hedge funds was looking to augment their home-grown valuation and risk procedures. This change in mentality was inspired by the imminent regulatory and market changes they were starting to see and hear about. Until then, the fund had enjoyed rapid expansion of assets under management, bringing with it portfolio diversification with potential for new investment opportunities and alpha generation. This expansion and diversification created an acute need for advanced financial analytics capable of providing visibility into portfolio risk and P&L decomposition.

Previously, the people who ran the hedge fund – they asked not to be identified – had relied on a third-party market data source and in-house risk valuation system. However, producing robust prices for a wide and burgeoning range of fixed income instruments requires a more powerful and flexible infrastructure, able to price any trade the manager wants. In addition to valuation, they also needed to understand the risk implications of their trading decisions intra-day. Reliable and transparent valuations and risk management were now a much higher priority for the London-based hedge fund.

To enhance its risk management, they also wanted better control over model usage, assumptions and measurement. With the current regulatory focus on transparency, a black box solution was no longer an option. Instead, they needed clear insights into the underlying assumptions and model usage, with a robust audit trail for traceability, giving management full confidence and control in its calculations.

Faced with these challenges, they implemented a software solution able to calculate risk sensitivities across yield and credit curves, and of using the information to perform the portfolio risk calculations, scenario analysis, stress tests and risk attribution required in todays market environment. Armed with this critical information, the 1B+ GBP AuM fund could now make informed decisions about how best to mitigate its risk exposures, and have the freedom to take on new trade types as required, regardless of the complexity the changing markets threw at them.

We then take a look at another fund with $100 million in assets under management without any previous analytics in place. (Again, the fund managers asked not to be named.) Launched in 2013, this fund was looking for a solution that would enable them to best manage their trading and risk analytics, while also being flexible enough to support their growth. Their primary challenges included quickly ramping up new portfolio managers as they came on board, and effectively managing their limited development and quantitative resources. With their sound investment strategies in place, they were looking to quickly scale up and the mechanism was to outsource their financial analytics system. Key areas of their risk management including reporting on numerous Value at Risk and profitability measures, as well as fine-grained scenario analysis. This gave them transparency into their risk analytics, enabling them to adapt their investment strategies. Given the regulation-intensive environment, dedicated risk processes helped illustrate institutional credibility and position the fund as an industry leader.

Two Sides of the Coin
These two examples show us the crucial importance of having mission-critical tools to monitor and manage both individual asset-specific risks and also aggregated multi-asset class portfolio exposures. This is the case for asset managers from across the traditional to alternative investment strategy spectrum. As they wrestle with ever more demanding client and regulatory expectations the penalties associated with non-compliance can be severe. A new KPMG International report, Investing in the Future: How Megatrends are Reshaping the Future of the Investment Management Industry, predicts the number of players in the global asset management industry will halve within the next 15 years. Many funds will be absorbed but the mid-sized funds that fail to appreciate the key role risk processes play in driving investment performance and enhancing their client service levels will be particularly vulnerable.

Change is happening. As risk analytics come of age, one of the big trends we are witnessing with trading desks, especially for buy-side firms, is a movement away from ad-hoc risk processes and the introduction of more formalized intra-day risk procedures. This has at least two important benefits.

First, it enhances risk oversight, and helps to more effectively monitor and manage risk on an ongoing basis. This can be a competitive differentiator when identifying well-managed funds.

Secondly, separating the trading and risk functions into dedicated disciplines frees the trading team to focus on core investment decision-making and alpha generation, and thereby achieve better performance. This does not mean erecting Chinese walls between the teams. It is important to have a flow of communication between trading and risk to optimize the effectiveness of both teams; but each side should operate with some level of autonomy.

Putting It Together
To improve performance and compliance in todays marketplace, it is vital that buyside firms understand their intraday risk exposures across a wide range of measurements and assets, with greater granularity and transparency. This requires an integrated, enterprise-wide risk management capability that can deliver robust pricing and valuations for the mix of instruments traded; and draw on sophisticated risk metrics to provide high quality, comprehensive and timely risk information to help shape investment strategies and determine asset allocations.

By ensuring these risk views feed into the pre-trade investment process, traders can make better trading decisions, enabling firms to enhance their risk-adjusted performance results and to satisfy those all-important regulatory and investor expectations.

Matthew Streeter is capital markets strategist and product marketing manager at FINCAD, a provider of OTC derivatives pricing and risk management solutions.