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Alpha Hedge West panelists offer fresh insight into risk management approaches
By Matthew Streeter CFA | September 18, 2013

After attending the recent Alpha Hedge West event at the Ritz Carlton San Francisco this week I can say that this was a great event put on by the IMN team and Seth Kadushin. It attracted a considerable group of buy-side industry leaders and was an excellent chance to hear the latest industry trends and best practices, and to network with some of the best minds in the buy-side and hedge fund eco-systems. The two-day event was filled with many thought-provoking panels. I have tried to capture in this posting the essence of the content from one of the well attended panels focusing on risk management issues, trends, and best practices. There was an undercurrent of risk management discussion throughout the entire conference so this was an important discussion. The panelists included representation from Perella Weinberg Partners, FINCAD, Children’s Hospitals and Clinics of Minnesota as well as Vanderbilt University Office of Investments—who all shared discussion on some of the hot-button risk management issues of today.

The first topic focused on how the panelists view risk management and how they implement risk management within their organizations. One saw risk as being a two-pronged approach, the first prong focusing on oversight and compliance; and the second focusing on advisory and internal consulting. Another panelist emphasized that there is a dedicated risk management role within their pension fund, with risk managed daily. At their organization, the risk management team will decompose the different trading activity on an ongoing (daily) basis to examine the risk. Another panelist indicated they have a team managing risk but don’t yet have a dedicated risk system in place. One important component of their process it to actively manage the continually changing correlations. Meanwhile another panelist focused on multiple risks, the concentrations of risk and how these concentrations change along with portfolio changes. This panelist highlighted that challenges that arise because often portfolios are composed intuitively from the investment perspective, and not put together to manage risk. It was also highlighted that there is a spectrum of institution types in the marketplace, with varying risk management needs, who are using varying analytics capabilities. Some of the examples are customers who are running different what ifs, different scenarios, and bumping (shocking) different curves like zero curves.

Some risk management challenges the panelists began to discuss focused on the transparency of their investment holdings. One panelist started out the discussion for this topic by saying that they require more transparency than they historically had, so they have moved out of fund of fund allocations and are now investing directly into hedge funds. Their allocation to alternatives (not explicitly hedge funds) is around 25% and at the current time, 15% are invested in hedge fund strategies. Another panelist indicated that to get transparency they are using separately managed accounts, where they’ve built an internal system to capture position-level data. This will allow them to look daily into their portfolios, and to get risk numbers from aggregators. This firm’s bias is to use some of the smaller funds which have greater transparency. Another vantage point was a firm using both risk and attribution numbers. It was commented that many different firms may not use the risk data that is already provided to them for decision-making. They provide client reporting for additional transparency. One additional transparency challenge mentioned by several panelists on the pension side is that they are finding that Form PF filing information is too stale and they could certainly use more dynamically changing form PF holdings and risk-related reporting and exposure information. Tony Webb from FINCAD mentioned another issue: the big transparency challenges in obtaining portfolio-level risk analytics. He is seeing this as an issue for clients’ Value at Risk (VaR) calculations. Position-level data must be available in a centralized manner and there is a continual drive to remove silos of information and improve aggregation.

On the topic of regulations, an ongoing challenge highlighted by Webb is that the curve-building for OIS curve migration is still an ongoing implementation challenge for many firms as part of the impact of central clearing brought on by Dodd Frank Title 7. Another relevant example is the need for better scenario analysis capabilities to evaluate hypothetical market environments. Collateral management and the what-if analytics on initial margin and variation margin are prime manifestations of this expanded scenario analysis. Webb described a research study that FINCAD has done recently with Sapient Capital Markets, analyzing the impact of different regulatory requirements for derivatives collateralization on the performance of a bond portfolio, to which derivatives were added to achieve a specific hedging goal. The study compared using exchange traded derivatives, cleared swaps, and non-cleared swaps with a typical pre-2008 swap strategy. Their analysis uncovered the portfolio drag due to the additional collateral requirements, which was assumed to be provided by the underlying asset base. This research study is available for downloading.

The panel discussion transitioned to discuss tail risk hedging, a topic coming up more frequently in many fund-level discussions. One perspective was that it is a costly hedging mechanism where firms are foregoing valuable alpha. An alternative effective way to tail risk hedge and prevent drawdowns is through stop losses either implemented through options or futures, depending on a mean reverting or momentum trending market. It was discussed that some plans hire tail risk hedging managers, with debatable effectiveness; while other focus on improving manager performance. One noted challenge with a tail risk hedging strategy is the hedging cost that is noted to be in the range of approximately 125 bps per annum. The measurement of effectiveness of tail risk hedging utilizing a Monte Carlo simulation framework, or with customized scenarios, was discussed.

The final discussion was related to operational risk where some believe it best, in an ideal world, to hire a dedicated resource to assist/ manage their operational due diligence process and it was noted that legal and compliance will often be central in their involvement of operational risk. One common trend across several panelists was the need for a broad view outside of the analytics and that there can’t only be a strict adherence to the quantitative models but also a continual evaluation of results in a greater framework. Webb indicated that it is best to look at a risk composite framework that is holistic and includes a number of metrics.

One panelist noted that they have an important need to manage (dynamically) correlations and sub-optimal to rely on historical correlations across the asset class allocations. Another panelist indicated that over the last 5 years that they have a great understanding/ management of the concept of liquidity risk. With regard to operational risk, they indicated that there is always room for improvement and that it’s important to not underestimate the board’s effectiveness in helping with operational risk issues. One effective way to improve the risk management process is by harnessing risk aggregators and looking at portfolios in different ways. This was an interesting panel and provided several interesting vantage points of risk management from several institutions in the institutional asset management space.