- Posted by admin
- On September 14, 2021
- AIFMD, Risk, Risk management, Risk managers, Risk Reporting, UCITS
Long story short, you, as a risk manager are short an option to the institution that has hired you. As circumstances dictate, it will exercise that option by way of an unceremonial, and worse, uncompensated exit of your good self from said institution. Your job is to manage that risk. Ironically, the hint is in the job title.
Reduction of the value of the option is the key principle here. Some folk look at this analogy and think the reverse, that is (1) the more risk in the business, (2) the more value of a risk manager, then (3) the more I will be paid. Parts 1 and 2 are undoubtedly correct but the higher salary will be paid to the person who replaces you. Rational folk tend to exercise expensive rather than cheap options. Remember you have already sold the option. Happily, as Keynes observed, wages are sticky, so your salary is highly unlikely to decrease just because you are doing a good job. It may even increase, but that is not to be relied upon.
One of the difficulties risk managers have in carrying out their function is the complete misnomer of a job title. I cannot stress this enough. The job of a risk manager is not and never has been to manage the risk of the fund. The job of the risk manager is to ensure that the actual risk of the fund is consistent with whatever the fund manager has told the board / investors / regulators etc. Risk reduction is not the name of the game. You will get as much grief for your active fund being in reality a closet tracker as you will for allowing your money market fund to invest in Venezuelan T-Bills (currently yielding 92,000%) and rightly so. As an analogy, if you consider a fund manager to be a painter in time, their current portfolio being a reflection of where they see the future, the risk manager is an art critic. A quality indifferent art critic, but a critic nonetheless. It is not relevant how good a painter the manager is, just whether the painting is in the right style, painted using the proper tools etc. If an investor pays for a Caravaggio and gets a Klimt, then that is a potential problem and the value of your option increases. Of course, if both portfolios are masterpieces, my experience is that there are significantly fewer issues. Sadly, it is also my experience that masterpieces are few and far between, at which point issues and option value may begin to pile up.
Whilst it would be wonderful to only be responsible for a single fund, the reality is that a modern risk manager looks after multiple funds and this is not a trivial task. For each fund, you will need know what the fund is meant to be doing and what it is not meant to be doing, identify a limited (4, 5 max) number of metrics to monitor the portfolio and track over time. This is the true skill of a risk manager and it is not trivial to carry out when portfolios can consist of a range of asset classes, instruments, trading frequencies, liquidity preferences etc. Once the metrics are identified and are being tracked, any significant changes result in alerts. Too many alerts in a short period of time are red flags, at which point a conversation with the fund manager is warranted. Probably nothing serious, but it all goes to ensuring that the manager knows that they are being monitored effectively, which reduces the potential for style drift, which lowers the value of the option you are short.
Finally, one of the best ways of altering the value of any option is to alter the implied volatility. As I said above, increasing volatility merely benefits your successor. However, attempting to reduce volatility is a fool’s errand. Funds are exposed to markets and in that arena, you get what you are given. The fund manager normally has the ability to alter the risk of a fund depending on market conditions and it is in the interest of a risk manager to assist in this process. This can involve designing risk reduction strategies, optimising the exposures of the fund or implementing any number of risk management tools. It can be very interesting work, however, from an action perspective it is always ex-post. Ex-ante risk management is another way of saying fund management and it is very important the risk manager knows where they are and where they are not in the food chain, and the delivery of performance is not and never has been part of their utility function.
Best of luck to all fund managers out there, but as they already know, much of their role has little to do with luck. It is about putting in place structures, processes and diagnostics, monitoring them on an on-going basis, and improving them when data and circumstances indicate. And continually reducing the value of that pesky option.