Both past and current decades remain marked by consistent uncertainty, as crisis after crisis has systemically rocked the financial markets. While these eventsdrastically affected performance, regardless of asset class, the ripples of unforeseen exposures, shaky positions, and unmitigated risks continue to impact investors. On the buy side, risk management was traditionally relegated to the middle or back office – analysed between the closing and opening bell. Risk was a night-time operation – an afterthought – post-trading, post-execution, and secondary to performance.

But emphasis on risk is changing, and growing. More and more, hedge funds are moving risk functions from a secondary process into the front office, proactively monitoring exposures in sync with trading and portfolio management functions. Greater risk emphasis is now placing funds in a better position to adjust strategies in real time and ultimately take advantage of trading and hedging opportunities over shorter horizons, all while simultaneously addressing transparency concerns for investors.

The risk hurdles
This shift in risk has myriad challenges:

• Transparency with investors;
• Potentially unforeseen costs;
• System completeness and reaction times;
• Breakdowns in process.

Risk management and the ability to achieve the desired levels of transparency continue to be very difficult for hedge funds of all sizes. According to an Aite study, this in part is a result of hedge fund managers placing guards around their investment strategy and approach for years to protect intellectual property, key algorithms, and other competitive components. [1] However, as investors now require transparency, improved data mining, analysis, and ongoing communications, hedge fund managers must reassess their tactics for making investment decisions. Achieving this new level of transparency requires sophisticated risk management controls vis-à-vis pre-trade compliance and post-trade analytics.

However, these controls and analytics have historically come at a steep price – a cost often prohibitive for a manager in the early days and months of operating. Citi Prime Finance’s latest hedge fund business expense survey reported that risk analytics, on average, cost $150,000 annually for a hedge fund with $100 million in assets – a cost that does not include the internal resources and back-office processes required to maintain and operate daily analytics. [2] Beyond cost, there are additional hurdles for fund managers. Simply being live on a risk platform does not guarantee adequate or timely processing.

After a custodian or clearing broker’s nightly processing routine, data sets are typically pushed to secure FTP sites to create beginning- or end-of-day portfolio data sets. These data sets may be updated intermittently through the course of the trading day (intermittent or batched uploads carry an implicit delay in portfolio discovery and risk analysis). If the main source of position and trade data is a broker’s books and record system, the fund manager’s risk platform must capture and aggregate trades from different execution and order management systems, executing brokers, sales desks, exchanges, and swap execution facilities to be truly ‘position-aware’.

A position-aware system takes into account broker feeds and updates, which are typically limited to trades executed or cleared by that broker. A fund using multiple primes or executing brokerages will need to aggregate data from all points of execution, matching and clearing.

Breakdowns in data feeds, errors, and latency are all events that can place portfolio activities in jeopardy. Systems that use a “delete and load” paradigm each day add single points of failure, latency, dependencies and costs and can challenge historical portfolio replication capabilities. And ultimately, fund managers are at the mercy of third-party systems that cannot adequately track and record all intra-day activities in real time, thus exposing positions to significant risk in the immediate term, and over longer periods.

When the risk platform is intra-day, batch-scheduled, or T+1, these exposures and limits are more difficult to set, track and control, especially in highly volatile markets. However, once a manager has configured risk tolerances and limits at the trader, portfolio or account level, the focus shifts to monitoring and ensuring all trading activity stays within those risk tolerances and limits.

Risk, right side up
Funds must sharpen their risk management and optimisation capabilities to accurately understand underlying drivers of risk, and balance the risk and return equation for different investors. [3] In order to identify opportunities, managers need a risk platform that ensures accurate valuations at all points in the trade lifecycle. While many platforms do this post-trading-day activity, the right risk platform should simultaneously identify risk, and through proper controls, address constantly changing market dynamics, correlations, volatility, and market microstructures in real time to tackle live market prices and valuations. For emerging managers, market and liquidity risk capabilities are must-haves. Established managers with higher assets under management and more complex strategies will want to include counterparty, operational, and legal risk considerations across multiple structures, accounts or portfolios. To tackle these capabilities, managers should look for a platform that includes:

• Real-time multi-dimensional trade capture and aggregation;
• Cross-asset class, multi-broker, and destination functionality;
• Risk sensitivity statistics;
• Standard formulaic profit and loss;
• Market exposure summations, by strategy, product, and account;
• Risk control and limit-setting functionality;
• One-click order cancellation, position fattening and administration;
• Early warning exception reporting.

Together, these capabilities can create new avenues of opportunity under a single umbrella of operations – achieving faster risk identification, better risk management, and smarter position adjustment and forecasting through position-aware standards and protocols.

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. Atruly 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.

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.

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.