There is a trite saying in finance that risk management is an oxymoron. As with most trite statements there is an element of truth here. Markets are generally unknowable, unforecastable, and trying to manage such markets is a fool’s errand. Unless you are very very very rich. Now I am not talking about Jeff Bezos rich, that is far too poor. I am talking about central bank rich. From 2008 to 2021 the Fed and the ECB spent about $24 trillion (that’s 12 zeroes…) keeping the markets quiet. And all other things being equal, it worked. However, it does seem quite a lot just to prove that risk management is not, necessarily an oxymoron.

Risk management, if taken seriously, is NOT an oxymoron. The key point is to be aware of what risk you are managing. Recently I had a bet with my son regarding the likelihood of Elon Musk buying Twitter. €20 to me if the bid did not go through, €20 him if it did. As markets fell, with it the price of Twitter and Elon started squawking, I offered my son the opportunity to exit for a €12 price. I felt I was managing my risk – Elon is capricious, time to reduce my exposure. My son declined. He realised what I, and clearly ex-post what the markets did not. That this was not a wager on the capriciousness of one person, but on that of the Delaware legal system. Sadly for me, probably not so sad for US corporate governance, it is not that capricious. If I had worked that out ex-ante, I would have asked for better odds!

At all points in the financial food chain risk is being managed, just not necessarily in a manner that is optimal for the specific financial institute. A fund manager’s appreciation of risk and reward can be acute but everyone in the role is aware of the real risk that is being run. Poor performance may lead to a bonus being cancelled. That is bad. Very poor performance may lead to a job getting tinned. That is very very very bad. Note the leverage. One very before poor leads to three verys before bad (this is a key insight of prospect theory, but that is for another day). One way of managing this risk is to perform well. That is risky. A, possibly, more rational approach is to take less risk. Less chance of getting a bonus, which is bad, but a seriously reduced probability of getting fired, which is very good. The main potential loser here is the fund and its investors, but one would struggle to say that active risk management is not being carried out.

Which is where the Chief Investment Officer (CIO) and Chief Risk Officer (CRO) comes in. It is their role, their risk to manage if you will, to ensure that the risk being taken is appropriate to the risk profile of the fund. Speaking as someone who has been a CIO in a multi-strategy hedge fund, I can assure you that it is far more effort to get a fund manager to increase risk that it is to get them to decrease it. The CRO in a hedge fund has a role closest to that of “Risk Manager”. Part of their responsibility is to imagine the things that can go wrong, in the different ways that they can go wrong and to map out potential strategies to mitigate the worst effects. The objective here is not to not lose money. That can only happen if you have an arbitrage – a bit like miracles, talked about far more than observed, or you are not taking any risk. The objective is to achieve the least-worst outcome consistent with the risk profile of the fund. In addition, practically speaking, getting a fund manager to execute is probably more difficult that designing the strategy in the first place. A least-worst outcome for the fund is, most likely, not a good one for the manager. Probably not great for the risk manager either. Given the option that they have effectively sold to senior management, they are, most likely, first to go when bad things happen.

The management of risk is a fundamental part of investment management. Making sure that the risks that are being managed as those that are in the best interests of investors should be paramount, but not trivial to achieve. This is what makes the regulated risk managers, the Designated Persons and Conducting Officers of the ManCos so important, but that is a discussion for another day. 

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