The Buy Side Perspective on Risk: Frequency, Aggregation and Process

While the incredibly rally in asset prices since lows in March 2009 points to a return to in risk appetite, investors are acutely sensitive to taking on unnecessary exposures. Any portfolio manager worth one’s salt must be adept at identifying and measuring the exposures critical to their investment strategy and optimizing the portfolio accordingly. The buy side must also take a similar attitude toward its operational risk so that losses only stem from ignorance rather than risk-seeking strategies.

Risk management failed in nearly every major area: portfolio volatility, liquidity risk, counterparty exposure and operational integrity. This was not just a watershed moment, where as Warren Buffet says, “It’s only when the tide goes out that you learn who’s been swimming naked”. We found out that a lot of people didn’t even know they were naked or if they would know what being naked could mean.

However, improving risk management practices and procedures is particularly tricky because a single weakness in the system can render useless the strengths of other components. Recognizing this, buy-side institutions rely increasingly on technology to closely identify the relationships between points of failure and to assure the overall stability of the risk management system. These technology solutions range from market risk monitoring, counterparty data, information security and disaster recovery.

Counterparty risk is exemplary of an area where collaboration offers great benefit. Traditional counterparty risk measurements such as credit ratings, and balances sheets are still relevant but given the poor track record of the credit rating agencies and the questionable methods in calculating balance sheets, they are met with increasing skepticism. There is also an increasing focus on understanding how some of the subsidiaries within larger entities can impact credit worthiness. The result is a focus on data management and collaboration.

Data management, and specifically, data aggregation is the most challenging aspect of managing enterprise risk, and as a result, counterparty risk as well. The buy-side CRO needs to know what the total exposure is to a given entity, whether that be direct investments in stocks and bonds, credit risk inherent in bi-lateral agreements, as well as assets (stocks, cash or CSA dollars) held in that counterparty’s name. Each of these transaction types is recorded in very different systems, none of which are likely to easily share information with one another.

The buy-side firms that are ahead of the curve in integration between investment professionals and trades are now involving traders in risk management. Indeed, participation in risk practices is and will be more prevalent within strategies and organizations where the trader is closer to the profit and losses of the portfolio itself. While this proximity tends to be clearer within options funds, many traditional asset managers are revamping trader compensation to be more explicitly aligned with the success of the strategy.

In fact, one of the signals traders look for is making sure that the prices are not only favorable but that they are inline with the credit rating of the firm offering the quote. An unusually aggressive quote can be a sign that risk practices at the broker are not particularly robust. We heard a similar line concerning prime brokerage rates. CFOs at hedge funds must weigh an aggressively lenient credit line from a prime brokerage with the implication of that credit line across a broader spectrum of hedge funds.

The TABB Group Vision Note on the Buy Side Perspective on Risk:
Frequency, Aggregation and Process
This 20-page report discusses how the buy side is improving its risk management technology and processes. The report highlights the challenges the buy side faces in measuring and monitoring market exposure, liquidity risk, counterparty exposure and operational controls and steps being taken to overcome those challenges. The report looks at how the buy side trader is involved in risk management and how that involvement is likely to increase in the coming years. There is also a detailed discussion on the buy side dependence on the sell side and how that impacts the ability to appropriately measure counterparty exposure.

The data in the report is based on conversations with over 107 buy-side equity and equity options traders. We interviewed both long-only asset managers and hedge funds and covered a wide range of strategies including long/short equity, statistical arbitrage, equity sector-focused, index funds, volatility and global macro. The conversations not only covered how the trading desk managed its own risk, but also how the trading desk participated in enterprise risk management.