The governance gap: What does great governance look like?
, Steven Baker
A look at Investment Risk: Adding value through independent risk oversight
There are many forms of uncertainty in life and in business, however, in most cases, people think of risk as the likelihood of unwelcome outcomes. This is true of operational risk (resulting from processes, people and systems) for which risk management boils down to a cost-benefit trade-off between the likelihood and impact of something going wrong versus the costs of mitigation.
Investment risk is more developed than many other sources of risk and concerns both sides of the distribution. While, at a high level, it represents the uncertainty of achieving expected returns, beneath swirl seas of opportunity where components and layers of risk are engineered, traded and priced, by entities with innumerable views and motivations, allowing those with information advantages, tolerance for carrying risk premia, trading skill or luck to achieve returns. Risk is uncertainty and without uncertainty in financial markets there would be no opportunity for reward.
Investors typically select specialist fund managers, with coherent approaches and proven skill in exploiting particular types of risk, to invest or trade their capital in the same fashion and with the same anticipated returns. Investor allocations are made, with the aim of achieving specific investment objectives within tolerance for overall risk, relying on the expectation that each fund will continue to deliver a risk and return profile consistent with prior results and their understanding. It is therefore important that funds remain true-to-form and deliver the overall risk-return profile intended by the investor.
To the profession, fund risk means anything that might affect the behaviour or functioning of the fund and is generally categorised into price risk, credit risk, liquidity risk, counterparty risk and operational risk. Given the complex interactions and spectrums of joint scenarios across those classes, investment risk spans the first four categories and deals with the combined linear and non-linear effects from myriad systemic, thematic or common, and specific effects found within each.
To manage the many sources and flavours of risk, sophisticated statistical models and tools have been developed for modelling, measuring and controlling (or indeed constructing) investment characteristics and risks. Armed with these systems, investment risk managers can investigate funds through various lenses and highlight disparities or inconsistencies between the makeup and levels of risk versus intended biases and targets. While effective portfolio risk alignment can optimise the likelihood of success, misalignment can result in unidentified and unwanted risks with unfortunate outcomes.
The potential benefits from an investment risk function to the investment process (and end investors) can be two-fold:
The first role should be performed independently and objectively from the investment processes and incentives of the asset manager. The second role is best performed alongside investment decision making within the investment process. Most larger asset management companies employ investment risk managers who work with their portfolio managers. AMX provides independent investment risk management / oversight over each of our funds.
After assessing the investment approach, expected risk profile and characteristics of the fund, we prescribe internal limits bespoke to the fund, spanning relevant areas of activity and risk.
Investors in AMX funds perform their own assessment of approach and skill, expected risk and reward before committing capital. It is not, therefore, our purpose to inhibit the fund manager from delivering their strategy or taking risk in line with objectives and client expectations – it is part of our role to promote such activity. So, in addition to controlling relevant investment risks, we also sense check and challenge managers on ‘tin risk’ or style drift – whether the fund looks like it is doing what it says on the side of the tin. At the end of the day, investment decisions belong to the investor.
"In addition to controlling relevant investment risks, we also sense check and challenge managers on 'tin risk' or style drift – whether the fund looks like it is doing what it says on the side of the tin."
We use separate data, systems and processes to the asset manager for monitoring exposures and risks in our role of controlling and steering the fund manager to stay en piste and ski between the poles (as much as is possible). But our approach to risk management is both objective and pragmatic, bearing in mind the limitations of risk modelling, variability in market conditions, practicalities of trading, discretion afforded to fund managers, and recognising that opportunity sets and strategies evolve.
In order to avoid unnecessary performance impact, our internal limits are set either side of the fund manager’s own limits or expected range – so in theory we should never see exceedances. In practice, funds actively and passively bump into or exceed our limits and we supervise remediations often. This is healthy; paid-for active management should not be averse to taking risk.
There are only two guarantees in investment: the future will differ from the past and your investments will not always go up. There are no guaranteed outcomes from risk management – risk is a gauge of the sources and levels of uncertainty.
We employ market leading risk systems (not all asset managers have access to such systems) and our control frameworks span all flavours of investment risk, but risk management is more than models and limits. The AMX investment risk team carries decades of experience in interpreting results, dealing sensibly with issues and working with fund managers to reach appropriate outcomes – all in the interest of investors.
We provide independent internal monitoring and control of each fund, versus permitted activities and risk framework, with an approach that is consistent in aim but bespoke by fund across our product range. Being independent, AMX risk oversight provides comfort to investors that each fund is adhering to the strategy and risk profile they allocated to.
Every asset manager has their own take on risk management: different models and capabilities; different assumptions and horizons; different motivations and standards. While it makes sense for each manager to develop and use methods bespoke to their strategies and needs, our independent risk oversight provides consistency in quality and approach to each fund.
AMX takes care of the operational aspects of running a fund – leaving the investment manager to focus on the challenges of trading their investment views and managing the portfolio. AMX’s governance structure and independent risk oversight provides investors with greater comfort that the funds they invest in will not go awry. For many clients this is an attractive layer to the fund range.
We prescribe an investment risk framework bespoke to each fund and suitable to each investment approach, that provides portfolio managers with sufficient allowance to implement their strategies and deliver risk and return as intended. We are not here to inhibit fund managers from doing what they should be doing and existing managers on the platform have found the experience constructive.
At the coal face, asset managers develop approaches, systems and interpretations in investment risk that are largely tailored to their strategies, views and trading needs – rightly so, since this information is valuable for enhancing the expected risk-return profile. But where the regulator has not stipulated exact methodologies for independent risk oversight and has instead encouraged managers to do as they see appropriate, this has allowed for wide divergence in objectivity, standards and depth – resulting in gaps and weaknesses that the end investor unknowingly wears. I think the fund management industry (preferably) or regulators (otherwise) should push for greater standardisation and depth in independent risk management and oversight to fulfill on the spirit of regulation and responsibility rather than the letter.
"… where the regulator has not stipulated exact methodologies for independent risk oversight and has instead encouraged managers to do as they see appropriate, this has allowed for wide divergence in objectivity, standards and depth."
I also think the industry owes investors far greater transparency. There is a significant gap in information and understanding between end investors and what those fund managers managing their money actually deliver, in terms of cost, risk and reward.
Much that impacts the investor is hidden or masked from them for the benefit of the industry. Yet in order to manage their own risks, investors need to understand the nature of underlying risk exposures, expected costs and rewards, and how their overall investments may play out versus their assumptions and intentions. This is a similar challenge to that faced by investment risk managers, who have tools and capabilities for highlighting key risk exposures and potential outcomes and experience in summarising and presenting such information in intuitive and graphical representations for non-specialists.
To find out more about AMX’s approach to governance or to discuss how your business can benefit from using our platform, please get in touch.
Photo credit: Ewan MacIver
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