Risk as a portfolio management tool Being position-aware means more than just data aggregation; it also includes supporting a host of application protocol interfaces and connecting to third-party trading technology, and brokerage and market data platforms. Managers should look for a risk platform that supports sub-millisecond pre-trade control, real-time position and portfolio monitoring to recalculate all performance metrics with accurate mark-to-market results (presenting position and trade-level data in configurable interfaces and reporting tools unique to a fund’s strategy), and real-time risk analysis. This enables the front office to make more informed decisions by factoring real-time position-aware risk calculations such as VaR, stress and shock, sector analysis, and liquidity exposures into the manager’s trading and hedging strategies.
At the granular level, advanced identification and perception of potential risks using market-tested risk analytics enable hedge funds to adjust leverage and add/decrease risk faster than their peers, and before market volatility clustering or auto asset correlation disintegrates hedges, accelerates losses or erases profit.
A fund manager’s risk toolkit should include models that can actively monitor risk accordingly. Portfolio characteristics, asset mix, liquidity, instrument types, and fund mandates all contribute to the model selection process. A truly flexible risk toolkit should provide fund managers with access to Value at Risk (VaR), expected shortfall, tail-risk estimation, stress testing, shock scenarios, liquidity modeling, and potentially risk-adjusted return on capital (RAROC), GARCH, and other multi-variate volatility and correlation models. And, next-generation multi- factor models may be needed to properly assess tail risks, changing correlations, default probabilities (in the case of structured and OTC products) and portfolio recovery rates.4 Furthermore, the platform providing risk analytics should be capable of replicating exchange, broker, and industry margin methodologies. This allows managers to correctly anticipate how their custodian views the manager’s exposure and what capital they are likely to require ahead of broker margin calls. Portfolio complexity will demand varied real-time and settlement pricing, security master data access, and – most importantly – that the models be position-aware.
Externally, regulation now mandates that certain funds provide transparency into key portfolio health metrics. Systemically Important Financial Institutions (SIFIs) as designated by the Financial Stability Board or as targeted by Dodd Frank, SEC, FASB and Basel III must also continuously model their capital requirements against risk-weighted assets and produce acceptable leverage ratios to stay in compliance or in advance of periodic stress
tests such as the ECB’s asset review. Other managers of capital may be subject to UCITS, AIFMD or Solvency II regulatory requirements. Thus, not only should firms be position-aware for investors and internal mandates, but also for capital requirement determination and potential regulatory requirements.
“Regulation now mandates that certain funds provide transparency into key portfolio health metrics. Systemically Important Financial Institutions (SIFIs) must continuously model their capital requirements against risk-weighted assets and produce acceptable leverage ratios.”
The advantages of automation The key to effective risk management is timely, accurate pricing and calculations across all instruments in the portfolio. This is achieved in part by the data and processes that power the risk platform. Emerging managers often lack the infrastructure in-house to accurately price and value portfolios, making it labour-intensive for portfolio managers and analysts to manage otherwise automated processes that hedge funds take advantage of, taking time away from alpha- generating activities. Thus, it is critical for managers to find and implement a risk management platform that is cost- and time-productive, complete with services that include:
• Global security master with reference data, historical time series, end-of-day, and real-time market data for all asset classes;
• Cross-asset portfolio warehouse that centrally stores and manages positions, and provides real- time position updates;
• Analytics engines to compute P&L, performance, risk, and shadow NAV either in a single view or across multiple interfaces;
• High-performance computing to compute large- scale simulations in true real time;
• Automated services to import portfolios from leading portfolio accounting systems and custodian banks into a central portfolio warehouse;
• Anytime reporting capabilities to provide flexible reporting services to the firm’s various stakeholders – including the ability to combine key portfolio and risk analytics with the fund’s proprietary portfolio information into structured data files or presentation-ready views that can be published out to investors at will;
• Global client service that is available 24/7 including operational support as well as market analysts to explain across all types of analytics reported;
• Built-in layers of redundancy and instantaneous recovery to ensure downtime of the analytics platform does not happen.5
Conclusion A position-aware risk management platform that properly aggregates all intra-day trading activity will provide portfolio managers with the ability to quickly, and cost-effectively model and react to exposures – expanding on best practices and staying within investment mandates. Rebalancing, reallocation, position fattening, liquidation, and tightening of limits can be accomplished by using a platform that provides a single point of access to multiple brokers and markets.
As funds and institutions move forward with more agile, market-appropriate strategies that keep up with investors’ needs and comply with regulation, risk adjustment must occur in real time and can only be possible through smarter platforms that incorporate manual trading decisions with automated data collection, analysis, and views to ensure compliance with external mandates and internal activities. THFJ
NOTES
1. Aite Group, “Hedge Fund Trends and Challenges 2014”, Part One, January 2014.
2. Citi Prime Finance, “2013 Business Expense Benchmark Survey”, November 2013.
3. Celent, “Buy Side Portfolio and Risk Management: Keeping a Sharp Eye on Risk, Returns, and Perfect Storms”, November 29, 2013.
4. Nassim Nicholas Taleb, “The Black Swan: The Impact of the Highly Improbable”.
5. Wall Street & Technology, “Safe haven: Why Managed Services are a Natural Fit for an Evolving Financial Industry”, 5 February, 2014.
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