Buy-side vs Sell-side Risk Management by kdb20316

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									Buy-side vs Sell-side Risk Management



Philip best                             11th November 2008
Buy-side: Frame of reference                                                                      2




                                                     Focus …              Performance:
        Performance:
        • Relative to a                                                   • “Absolute”
           Benchmark                                                        (relative to cash)


        Long only                                                                Hedge Funds


        Passive                                                                          Active




                                                               … on active fund management



Threadneedle presentation with generic slides 2008
Banks versus Asset Management (AM)                                                         3


    Key business characteristics drive the differences in risk management


        Banks                                        Asset Managers

             Trade for own account                     Invest on behalf of clients

             Material financial leverage and           Typically no financial leverage
              associated funding requirement
                                                        No funding requirement –
             Driven by $ profits                        generally long of cash

                                                        Driven by market level and
                                                         relative performance




Threadneedle presentation with generic slides 2008
Role of risk management (1)                                                                4


    Risk Control


                                  Banks                             AM’s
             Control is paramount                      Control is paramount
             Often separate risk function              Often separate risk function
             Manages limit framework                   Limit framework dictated by
                                                         investment management
             Includes stress testing                    mandate
             Includes credit & counterparty            Unlikely to include stress
              risk                                       testing
                                                        Unlikely to include credit risk
                                                        But will include counterparty
                                                         risk




Threadneedle presentation with generic slides 2008
Role of risk management (2)                                                                 5


    Front office risk support


                                  Banks                            AM’s
         Partnership                                   Partnership – but some
         Examine trade ideas
                                                         element of control
                                                        Stress testing
         Understand new products
                                                        Portfolio construction
         Market analysis
                                                        Focus on assisting with the
                                                         generation of consistent returns
                                                        Ad-hoc market analysis
                                                        Part of the commercial
                                                         proposition




Threadneedle presentation with generic slides 2008
Risk management in Asset Management (1)                                      6




    Client mandates are deliberately loose – in order to avoid litigation
     and to allow investment freedom. They are part of a legal contract.

    Market and credit risk losses are borne by the client

    Counterparty losses should also be borne by the client

    The exception to the above is in the case of negligence and
     investment errors

    Therefore the biggest (only) risk is Operational risk.

    Whereas market, credit and counterparty risk are borne by the
     shareholders (and staff in terms of bonus impact) in a bank.




Threadneedle presentation with generic slides 2008
Risk management in Asset Management (2)                                       7




    Still heavily focused on Tracking Error (volatility of the performance
     difference – portfolio vs benchmark) – but is the direct relative
     performance equivalent of VAR

    The financial instruments and portfolios are often simpler than
     encountered on the sell-side

    The number of funds can be very large and positions cannot be
     aggregated as each fund is a separate entity – this presents some
     interesting challenges:

            What does a summary risk report look like?

            Can’t see the wood for the trees




Threadneedle presentation with generic slides 2008
Leverage on the buy-side?                                                                8




    Typically there is no, or low, financial leverage in asset managers

    However the ratio of assets under management to capital is typically very large –
     1000+ !!

    Therefore a successful claim for breach of mandate can wipe out the capital
     base very easily.

    So there is operational risk leverage …

    Biggest risks to AM’s are associated with the funds that clients expect to be low
     risk – e.g. money market funds in the US




Threadneedle presentation with generic slides 2008
The risk management revolution – what happened?                                                9




    On the Buy-side? Not much !

    Huge revolution in sell-side risk methods and framework
     (though given the last year this is clearly still work-in-progress)

    Key drivers in development in sell-side risk management:

            Losses from
              – Leverage
              – complexity and proliferation of financial instruments and trading strategies
              – Fraud / rogue trading

            Regulatory regime – heavy burden of proof of risk management process




Threadneedle presentation with generic slides 2008
AM risk management – where is the buy-side now?                               10




    Still focused on tracking error

    Under-developed stress testing capability

    Primitive counterparty risk management capability

    Basic operational risk management

    Not all bad however:

            Basel II has pushed banks toward a reliance on credit risk and
             operational risk models
            Whereas AM’s remain focused on managing and mitigating
             tangible and specific risks




Threadneedle presentation with generic slides 2008
AM risk management – where next?                                               11


AM risk management is going through a revolution now – but why?
    UCITS III

            Regulatory regime

            Allows use of leverage and derivatives

    Hedge funds

    Bi-furcation of the industry into index replication and Alpha
     generation:

            Alpha generation requires product and investment innovation and
             increased complexity of instrument usage

            Absolute return

    Increasing sophistication of institutional investors

    Credit crisis – but change was happening before

Threadneedle presentation with generic slides 2008
Is buy-side and sell-side risk management converging?                        12




Yes !

            The regulatory regimes are converging

            Sell-side techniques are already migrating

Is this a good thing?

            Yes – as long as the buy-side learns from but does not repeat
             experiences from the sell-side.




Threadneedle presentation with generic slides 2008
Contact & other                                                        13




 Philip.best@threadneedle.co.uk

 Disclaimer:
 The views expressed in this document are those of the author and do
 not necessarily reflect the views of the Threadneedle




Threadneedle presentation with generic slides 2008

								
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