The management of risk is playing an increasingly important part in the implementation of an investment strategy. Fund managers may be paid to seek risk, but they will be paid more if they avoid the “wrong kind” of risk – the kind that leads to worse performance than their peers, Laurence Wormald, director of BITA Plus, told delegates of last month’s BITA Plus event. The wrong kind of risk is unanticipated risk. Like the British Rail “wrong kind” of snow, there really are differences between one kind of risk and another, though they may not be obvious to the casual observer. This is where the fund manager’s skill comes in when volatility strikes.
Fund managers who take the trouble to think carefully about their investment strategy in risk terms should be able to safeguard against the unpredictability of markets and the unwelcome consequences of unanticipated risk.
Wormald told delegates a story about a US pension fund manager who lost his mandate because he couldn’t give a satisfactory explanation of why his “S&P 500” fund over-performed the benchmark by 2-3% for four quarters in a row.
It may sound unlikely that investors would be unhappy about over-performance but, if the fund manager succeeded by ignoring his own predictions, or by claiming completely the wrong level of risk in the fund, the client would be right to be suspicious, said Wormald. This kind of performance could be a fluky out-come to unanticipated risk.
The lesson is that to control risk, the fund manager needs to understand it. The over-performing manager shouldn’t have any problems keeping his job, but he needs to improve his story. The fund manager’s investment strategy should demonstrate a convincing link between the results (in terms of performance and risk) and his investment skills.
Wormald advised delegates to think about each component of their strategy in terms of risk. To do this, they need a risk engine, which can provide quantitative measures of the risk terms. By breaking down the risk, the fund manager will be able to see how market volatility has affected his portfolio depending on his exposures to different risk factors such as currency, country, or industry.
To test his investment strategy, the fund manager will need to rigorously “back test”, using methods such as Monte Carlo simulations to critically examine his risk models. The fund manager needs to look out for the periods when the difference between anticipated and realised risk is too big for comfort – when the wrong kind of risk came along, he said.
This is not to say that the wrong type of risk can be avoided completely, he added. Fund managers are not paid to deal with catastrophic risk. But they are expected to maintain performance in the face of unpredictable markets.
Wormald reminded delegates of the 1998 Asian crisis: “We know all risk models will fail at some point. Dealing with risk is not about having the best risk model in the world, but knowing what to do when the risk model goes wrong.”
With increasing market turbulence, the fund manager needs to confront the notion of unanticipated risk and the fact that all risk models have their limits. If he employs a rigorous testing and modelling strategy, then he will be able to control his risk and continue to reap the rewards of a coherent investment strategy, Wormald concluded.
Matthew Lovatt, CEO of Quaestor Investment Management, spoke about the growing interest in alternative investment strategies, which has become a feature of the asset management industry over the last decade, with significant numbers of new hedge funds opening for business.
He argued that in increasingly challenging markets, hedge fund strategies offering investors access to uncorrelated sources of return could become thought of as ‘conservative’ rather than ‘alternative’ – given the opportunities for diversifying risk.
Although it is true to say that hedge fund products vary greatly in their return targets and risk profiles, evidence shows that they can succeed in delivering superior returns with a lower risk of loss. While conventional (long-only) managers generate returns through exposure to the markets and generally have equity indices as their benchmarks, ‘non-directional’ hedge funds seek return irrespective of market movements. Therein lies their appeal in view of market volatility.
Equity market-neutral funds are structured as balanced portfolios of long and short investments. They work by generating return from the relationship between selected investments with neutral exposure to risks such as currency, sector and industry.
Yet as with conventional investments, Lovatt argued that alternative managers must focus on careful identification and management of the risks within their funds: “Too often risk management is added as an adjunct to the process. Risk management should be anticipatory and pro-active. The manager should know what the risks are and understand them”. He urged delegates to be alert for warning signs such as any move away from the stated return statistics of a fund or a lack of sophistication in risk management techniques and technologies.
Looking to the future, Lovatt expects that the flow of funds towards alternative strategies will continue to increase. And those managers able to demonstrate superior and consistent returns utilising rigorous, effective and sophisticated systems for the management of risk will be particularly favoured.