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Buy-side vs Sell-side Risk Management. Philip best. 11 th November 2008. Active. Passive. Buy-side: Frame of reference. Focus …. Performance: “Absolute” (relative to cash). Performance: Relative to a Benchmark . Long only. Hedge Funds. … on active fund management. Banks

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Buy-side vs Sell-side Risk Management


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buy side vs sell side risk management

Buy-side vs Sell-side Risk Management

Philip best

11th November 2008

buy side frame of reference

Active

Passive

Buy-side: Frame of reference

Focus …

  • Performance:
  • “Absolute” (relative to cash)
  • Performance:
  • Relative to a Benchmark

Long only

Hedge Funds

… on active fund management

Threadneedle presentation with generic slides 2008

banks versus asset management am
Banks

Trade for own account

Material financial leverage and associated funding requirement

Driven by $ profits

Asset Managers

Invest on behalf of clients

Typically no financial leverage

No funding requirement – generally long of cash

Driven by market level and relative performance

Banks versus Asset Management (AM)

Key business characteristics drive the differences in risk management

Threadneedle presentation with generic slides 2008

role of risk management 1
Control is paramount

Often separate risk function

Manages limit framework

Includes stress testing

Includes credit & counterparty risk

Role of risk management (1)

Risk Control

Banks

AM’s

  • Control is paramount
  • Often separate risk function
  • Limit framework dictated by investment management mandate
  • Unlikely to include stress testing
  • Unlikely to include credit risk
  • But will include counterparty risk

Threadneedle presentation with generic slides 2008

role of risk management 2
Partnership

Examine trade ideas

Understand new products

Market analysis

Role of risk management (2)

Front office risk support

Banks

AM’s

  • Partnership – but some element of control
  • Stress testing
  • Portfolio construction
  • Focus on assisting with the generation of consistent returns
  • Ad-hoc market analysis
  • Part of the commercial proposition

Threadneedle presentation with generic slides 2008

risk management in asset management 1
Risk management in Asset Management (1)
  • Client mandates are deliberately loose – in order to avoid litigation and to allow investment freedom. They are part of a legal contract.
  • Market and credit risk losses are borne by the client
  • Counterparty losses should also be borne by the client
  • The exception to the above is in the case of negligence and investment errors
  • Therefore the biggest (only) risk is Operational risk.
  • Whereas market, credit and counterparty risk are borne by the shareholders (and staff in terms of bonus impact) in a bank.

Threadneedle presentation with generic slides 2008

risk management in asset management 2
Risk management in Asset Management (2)
  • Still heavily focused on Tracking Error (volatility of the performance difference – portfolio vs benchmark) – but is the direct relative performance equivalent of VAR
  • The financial instruments and portfolios are often simpler than encountered on the sell-side
  • The number of funds can be very large and positions cannot be aggregated as each fund is a separate entity – this presents some interesting challenges:
    • What does a summary risk report look like?
    • Can’t see the wood for the trees

Threadneedle presentation with generic slides 2008

leverage on the buy side
Leverage on the buy-side?
  • Typically there is no, or low, financial leverage in asset managers
  • However the ratio of assets under management to capital is typically very large – 1000+ !!
  • Therefore a successful claim for breach of mandate can wipe out the capital base very easily.
  • So there isoperational risk leverage …
  • Biggest risks to AM’s are associated with the funds that clients expect to be low risk – e.g. money market funds in the US

Threadneedle presentation with generic slides 2008

the risk management revolution what happened
The risk management revolution – what happened?
  • On the Buy-side? Not much !
  • Huge revolution in sell-side risk methods and framework (though given the last year this is clearly still work-in-progress)
  • Key drivers in development in sell-side risk management:
    • Losses from
      • Leverage
      • complexity and proliferation of financial instruments and trading strategies
      • Fraud / rogue trading
    • Regulatory regime – heavy burden of proof of risk management process

Threadneedle presentation with generic slides 2008

am risk management where is the buy side now
AM risk management – where is the buy-side now?
  • Still focused on tracking error
  • Under-developed stress testing capability
  • Primitive counterparty risk management capability
  • Basic operational risk management
  • Not all bad however:
    • Basel II has pushed banks toward a reliance on credit risk and operational risk models
    • Whereas AM’s remain focused on managing and mitigating tangible and specific risks

Threadneedle presentation with generic slides 2008

am risk management where next
AM risk management – where next?

AM risk management is going through a revolution now – but why?

  • UCITS III
    • Regulatory regime
    • Allows use of leverage and derivatives
  • Hedge funds
  • Bi-furcation of the industry into index replication and Alpha generation:
    • Alpha generation requires product and investment innovation and increased complexity of instrument usage
    • Absolute return
  • Increasing sophistication of institutional investors
  • Credit crisis – but change was happening before

Threadneedle presentation with generic slides 2008

is buy side and sell side risk management converging
Is buy-side and sell-side risk management converging?

Yes !

  • The regulatory regimes are converging
  • Sell-side techniques are already migrating

Is this a good thing?

  • Yes – as long as the buy-side learns from but does not repeat experiences from the sell-side.

Threadneedle presentation with generic slides 2008

contact other
Contact & other

Philip.best@threadneedle.co.uk

Disclaimer:

The views expressed in this document are those of the author and do not necessarily reflect the views of the Threadneedle

Threadneedle presentation with generic slides 2008