Why fund risk management is a bigger challenge

May 20, 2015 09:45
Operational risk can come from internal factors such as so-called “fat fingers” which are human typing errors in executing a trade. Photo: The Telegraph

The 2008 financial crisis revealed the true extent of the risks faced by the asset management industry.

Since then, fund of funds, private equity firms, hedge funds and institutional investors have been struggling to overcome the new challenges and the growing list of risks they have to control or be aware of.

The establishment of a risk management function and internal reviews have recently become a central area of regulatory focus.

Let’s look at the major types of risks.

Systemic and unsystemic risk

A major yet unavoidable risk for the industry is systemic risk, which refers to uncertainties arising from unpredictable events such as changes in inflation rates, exchange rates, interest rates, political instability and war.

This type of risk cannot be completely avoided nor reduced because the risk is not specific to a particular company or industry.

Then there is another category called unsystemic risk, which is specific to a company, market, economy, industry and country.

Through diversification into a broad range of asset classes, a fund manager can, to some extent, reduce the investment risk and the volatility of the overall portfolio, but it is important to note that such risk cannot be eliminated.

Diversification can prevent a fund from suffering a total loss but it cannot remove the possibility that the investment results could fall below expectations.

Operational risk

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people or systems, or external events.

Past operational failures and trading scandals have highlighted the importance of operational risk management that can never be overstated.

All hedge funds face a range of operational risks on a day-to-day basis in different areas of operation and they have to comply with a continuous increase in related regulations.

Operational risk can come from internal factors such as so-called “fat fingers” which are human typing errors in executing a trade.

There are also problems originating from NAV miscalculation. The fund will also be in trouble if unauthorized trading happened, worse if such trading is not identified promptly.

External factors also add operational risks.

For example, if fund managers fail to adjust to changes in legislation or accounting standards, such delay in compliance can cost dearly in the form of escalating litigation and penalties.

Operational risks come from all directions and are therefore far from easy to cover comprehensively. The lack of quantification tools for this type of risk and the absence of common consensus on how they should be managed, make lives of fund managers even harder.

Liquidity risk

Asset management firms also face liquidity risk, which refers to the concept that the firm cannot meet short-term financial demands, usually occurring due to the inability to convert assets or securities to enough cash.

There are two types of liquidity.

Position liquidity refers to how quickly the financial assets of a fund can be converted to cash at a known value. On the other hand, fund liquidity refers to how fast a fund’s investors are allowed to exit according to the stated terms.

In the past few years, worldwide economic challenges including higher liquidity costs and a more unpredictable market have made things more difficult for risk managers.

Most liquidity issues have arisen due to a lack of formal stress testing procedures. The Securities and Futures Commission advises that firms develop appropriate stress management procedures, be more vigilant and conduct regular stress testing.

As asset managers are employing complex investment strategies, it is now an industry standard for them to maintain stringent risk management procedures commensurate with their business.

In light of the above, most asset management firms now have an independent risk manager to establish a good system of checks and balances.

Hedge funds are also frequently reviewing their risk management policies and procedures to instill investor confidence in themselves and the asset management industry as a whole.

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Josephine Chung is Director of CompliancePlus Consulting Ltd. and Bonita Hui is a compliance analyst