These indicators coupled by the 2008 financial crisis, provide risk managers with an invaluable learning experience. The role of Risk Managers and Chief Risk Officers is evolving and the fund industry is no exception. There are currently two major drivers of the evolution of fund risk management – regulatory requirements and investor pressure; and it is in the interaction of these two forces that one can observe both the current state and likely path of risk in fund management.
Regulatory requirements appear to be the most important driver in the evolution of risk in fund management. The Alternative Investment Fund Managers Directive (AIFMD 2011/61/EU) and subsequent level 2 Regulation (EU 231/2013) have profound implications for the role of the risk manager in an investment fund. In regards to governance, risk management is expected to be an independent control function. In regards to operations, risk management along with fund management are considered to be the core functions in a fund. More importantly, in regards to job specification, a substantial amount of energy is required to produce the risk information required. The regulatory reporting templates are demanding; not only the volume of the raw data that must be captured have increased significantly, but analytics should now be calculated monitored and reported on market and liquidity risk as well as credit and counterparty risk. This means interfacing of systems, collecting specified raw data in large volumes, creating a risk database with historical-drilling capability, conducting extensive data consistency checks and reconciliations, replacing spreadsheets with more automated tools or risk engines, and using such tools for producing all the risk sections of the sixty regulatory templates that must be filled in in XML format over 250 separate line items on a quarterly basis. What is remarkable about this legislative overhaul is that it is most likely current best practice anyway for large asset managers. The profound difference of AIFMD is the intention to apply such obligations to managers with smaller funds in the few hundreds of millions rather than the tens of billions. Even sub-threshold AIFs, with total assets below 100 mio euro, or 500 mio if unleveraged and with a 5 year lock up, have increasing regulatory reporting requirements related to risk analysis, risk disclosures, solvency, transactions reporting under EMIR, MiFID 2 and other EU Directives.
The second major driver of the evolution of fund risk management is investor pressure. Firstly there has been a demand for enhanced transparency with increased frequency of reporting on the risks that funds are 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 need to 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 of the invested fund. Investor pressure is also observable in the decreasing tolerance for breaches in the fund’s investment objective and strategy as prescribed in the prospectus document. Whilst previously, it was possible for breaches to be resolved over a significant period of time, that tolerance has significantly diminished. At any point in time the fund manager needs to observe the fund's exposure against all sorts of criteria that have been identified in its investment prospectus. Quite often, additional internal limits may be put in place, which is a best practice. Such limits might apply to a vast universe of parameters including asset allocation based on region, currency, instrument type, issuer, position sensitivities. Although the ultimate responsibility for adhering to such limits lays with fund managers, the risk manager is typically in charge for monitoring such investment compliance. Therefore, the capacity of a risk manager’s systems to monitor a limit structure in a timely and accurate manner is of utmost importance. In the case of limit breaches a strict requirement to be compliant by close of business is not an uncommon feature in funds launched today. Regulators may be taking a more long-term view in maintaining risk exposures within set limits, but at the same time investors are requiring assurances that their funds are being managed in a manner consistent with the prospectus on an ongoing basis.
Regulatory and investor pressure have therefore greatly expanded the role of fund risk managers, both in terms of scope and responsibilities. However, it is the interaction of these two that has the greatest impact on the role of risk management. And this lies with the need to be able to handle and process large data volumes efficiently and effectively. Excessive amounts of time were previously spent attempting to get the indicative data necessary to carry out an analysis or 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 actual risk exposures and ensuring these are in line with the fund’s stated risk appetite as reflected in the regulatory and internal limits, and the identification of risk mitigation measures and remedial actions. Nowadays, remote, secure and fast functionality, workflow automation, systems, and data processing capability allow risk managers 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. Risk managers are, or should be, well equipped for analysing market risk (e.g. monitoring position size versus risk limits, stressing the risk factors that are likely to impact portfolio value and quantifying the P&L of movements in the underlying positions), monitoring counterparty risk (analyzing the credit risk of issuers and counterparties, their credit risk migration probability, the loss given default) as well as managing other risks such as the risk of unplanned redemptions and other liquidity issues that may be expected or unexpected as well as operational risks (e.g. system downtime or software failures, investor inter-personation/fraud risks, model validation issues).
To conclude, the role of fund risk managers has evolved far and fast in the past five years. From a partially ineffective bystander, the risk manager now has the regulatory imposed powers and (should have) the tools to effectively monitor and if necessary limit the various risks to which a fund is exposed. It seems likely that such powers and tools are likely to be enhanced further in the next few years. This prospect may be viewed with some trepidation by other stakeholders in the fund management business, particularly investors. Increased power to limit downside risk may be perceived as a threat for limiting upside potential and positive 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 today and you may be out of business by tomorrow. 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.
Author: Dr Marios Kyriacou, Senior Consultant with MNK Risk Consulting Ltd
Marios Kyriacou is a Senior Consultant with MNK Risk Consulting Ltd, a financial services advisory firm assisting Banks, FX Brokers, Fund Managers and other regulated financial institutions with regards to their optimal structure and set-up, licensing, and regulatory compliance. He has 18 years’ of experience in the banking and financial services sector. Previous roles include Head of Risk Management of Piraeus Bank Cyprus for eight years and Risk Manager with BNP Paribas UK for another 8 years. He holds a Ph.D. and M.Phil. (Distinction) from Cambridge University and a B.Sc. (First Class, Honours) from Warwick University. Chartered Statistician by the UK Royal Statistical Society. Dr. Kyriacou is appointed as a Board member in several investment companies and teaches risk management at the University of Cyprus.
