by Ian Lumb
Over the past decade, the Chief Risk Officer has been elevated to the driver’s seat, charged with navigating a more challenging, vaster terrain with an entire organization in tow. To that end, CROs and CIOs are now in urgent need of a modern, innovative, and technology-led solution that encourages asset managers to simultaneously embrace short-, medium- and long-term views of risk.
To learn how risk management is bleeding into the front office and what that means for portfolio managers, traders and an emerging team of ‘hybrid risk managers’, read here.
In today’s (and tomorrow’s) increasingly risk-centric landscape, a risk management solution is analogous to an enterprise GPS system. In the short term, it tracks current position, next steps, and any immediate dangers. In the medium-term, continual progress checks alert the driver to immediate hazards and new and better routes that keep the company on track. And in the long-term, a risk GPS system provides an overview of the quickest, shortest, cheapest route – navigating around large, foreseeable hindrances – to reach desired objectives or get from point A to point B.
Below are five questions to ask yourself when assessing the value of your existing risk solution and the role it plays in helping your organization navigate risk.
Does my risk management process help me manage my risk?
In other words, “to what degree does my risk system inform my risk strategy?” In the most general sense, let’s say that your investment objectives are firmly defined and well understood. Your risk process should then provide a clear direction and valuable insight into the return you need to make and the level of risk to take in order to meet your targets.
This means a practical grasp on restrictions (what are my risk limits? What should I not be investing in?) and exposures (how much do I own – portfolio value, size, weight, notional? How sensitive is what I own to market moves – Delta, Gamma, Beta, DTS?) as well as an understanding of how manager performance and behavior affect the success of your overall strategy (Do my managers make the right decisions? Are losses treated differently than profits in trading strategies?).
Subsequently, a risk system should also help you retrospectively decompose alpha in order to recognize whether your managers are skilled or just lucky and whether you imposed the correct mandates or not (Are ESG decisions or restrictions improving my performance?).
How are we measuring risk?
Risk is far more than a single number. First, understanding the metric(s) your organization is currently using to measure risk will invariably pave the way for a more comprehensive, sophisticated strategy that incorporates a multi-faceted approach to identifying, measuring and reporting risk.
Since there is no standard protocol for determining asset or portfolio risk, your system should go beyond a single number (e.g. VaR calculation) and incorporate risk measurement from a variety of angles, across exposures, sensitivities, stress testing and scenario analysis and all asset classes. A good risk system should incorporate measures of volatility (How risky or volatile are the assets I’m exposed to? Do the assets I invest in have any tail risk? Are the return profiles non-linear of my assets?) and correlation (how diversified or correlated are my assets?), both of which are essential to identifying potential sources of portfolio risk. Does your risk system have advanced scenario analysis and stress testing capabilities? If not, you’re missing a vital trick in balancing and hedging portfolio risk—more on that below.
Are we confident in our portfolio risk analysis?
Regardless of your management approach – passive or active – your risk solution should be giving you a holistic, comprehensive analysis in order to boost the accuracy of your strategy. Does your current risk system provide timely insight that feeds your risk management plan (diversification rules, potential losses and ‘what if’ scenarios?).
This includes understanding how risk variables directly affect investments: how much you could lose with a given confidence (VaR – parametric, historical or Monte Carlo?). Can you lose more than you invest? What collateral do you have to post/accept?
In addition, advanced stress testing gauges how certain factor shifts, market moves or historical events affect your portfolio, and which stress events would cause the worst catastrophic losses for your organization.
Do I really understand where my risk is coming from?
In 2018, you should understand where your risk sits across all portfolios. Not only should your risk system provide comprehensive measurement, it should also provide a granular view of high and low concentrations of portfolio risk.
Risk decomposition uncovers the exposures contributing the most to portfolio volatility to help inform your overall risk strategy. Introducing risk attribution, factor exposures, stress tests and factor shocks help to address the following questions:
- How does my risk decompose into factors or classifications?
- How does my portfolio move if I stress a given factor?
- Do I have any unconscious bias in my portfolios, behavioural risk or unrecognised factor exposures?
- Why has my risk changed / why did I breach my risk limit?
- Am I managing risk consistently across all funds with similar mandates?
Is our technology future-proof?
The patchwork of siloed point and in-house legacy systems still used by many asset management firms poses an inherent problem for CROs in search of a uniform, enterprise-wide view of risk. If the system used in the front office is different to the one used in the middle office, risk analysis will always be unreliable and fragmented, and—more seriously—produce inconsistent reporting.
What constitutes the backbone of your risk system?
The development of modern, scalable solutions that manage the diverse risk needs of an entire organization is in the cloud. Legacy tools and platforms simply don’t have the computational power required to satisfy today’s risk requirements, nor can they scale up and down in real time to accommodate fluctuating demand.
What is cloud-hosted vs cloud-native and why it matters?
Need help evaluating your risk needs? Contact us to learn more about how Axioma’s award-winning risk management solution can help your organization.
