Considerations when implementing a risk management system, part 2

Continuing from my previous post, I will address the next in our series of questions to consider when implementing a new risk management system.

Part One:

• Who are the Stakeholders?
• Why do you need risk?

Part Two:

• What are your options?
• Where do you need to see risk?

Coming in Part Three:

• How should you implement your solution?
• When should this take place?

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What are your options?

Now that we are clear about who we are trying to please and the reasons we need risk in the first place, we can tackle finding the right risk model for the job. To do this we need to be able answer three primary questions:

1. What market(s) do you invest in?
   
   Firms often try to use a single broad model to analyze many smaller markets that they care about. While this may be a more cost effective option then buying many market-specific models and the large model may, in fact, “cover” all of the securities they care about in the smaller markets, these firms are not taking advantage of the research and development performed by the risk vendors to design their models for specific purposes. For example, it seems to be more and more common to use a Global Equity model to analyze equity portfolios that invest only in single countries. While you will certainly be able to calculate some risk numbers, I would argue the value of these numbers is reduced. Most global models are designed to use or capture factors that apply across many diverse markets and therefore are ideal for global investors, while single country models typically use or pick up factors that are unique to a single market. Imagine using a Global model to analyze an Australian equities portfolio. Most global models will likely be dominated by factors that primarily affect a few large countries; is the predicted risk of such a model ideal for this situation?
   
   
2. What asset classes do you care about (equity, fixed income, derivatives, unlisted assets, etc.)?
   
   You can easily extend the rationale from point 1 to multi-asset class models. If you could, would you use an equity model to analyze a REIT portfolio?
   
   
3. What are the right time horizons (Investment Horizon vs Model Horizon)?
   
   What about the often overlooked time horizon? If some of your portfolios are short term by nature, looking at an estimation of risk based on 12-month time horizon would not be particularly useful. What if you have a long-term investment horizon, but you want to understand your short term risk exposures? There are certainly legitimate and very good reasons to use models calibrated for different time horizons; just make sure that you understand the limitations and applications of such models before making a decision about which model is right for you.

In the end, I think we need to keep sight of something we already know, but often push to the background: all risk models are estimates based on some simplifying assumptions. One model is not going to be ideal for all purposes and situations. We need to do our best to align the model assumptions with our view of the world and our reasons for analyzing risk in the first place. If I care about measuring sensitivity to short-term market volatility, then I should not expect a model with a long horizon to provide meaningful insights.

The ultimate goal should be to fit models to our purposes. In many cases this may mean using multiple risk models.

Where do you need to see risk?

At this point, we have identified (from our list of stakeholders) the people/groups that care about risk, but as I have mentioned, the degree to which these stakeholders care can certainly vary significantly across individuals and groups. My goal here is to help you think about communicating what you know in a way that is meaningful to the end consumer of the information.

I have seen numerous investment managers who already have a risk system in place follow a business model where a small team of risk professionals analyze, generate, and communicate risk results for everyone else in the firm. While there is no denying that having a risk team is still a great idea (who better to set up standards, objectively monitor risk, and communicate results then people who specialize in exactly this type of analysis?), there are definitely some good reasons to make this information more accessible throughout a investment firm. For example, technology and software have improved dramatically since risk systems first came into use, which should allow for much broader and more efficient distribution of risk analytics across a firm. It still may fall to a special risk team to monitor and manage risk across portfolios, teams, etc., but there is certainly no reason for others who might be interested in portfolio risk (e.g., PMs, CIOs, Analysts) to have little or no access to the same information on a regular or ad hoc basis. In other words, there is no technological reason for limiting access to risk data to a single person or team.

At the end of the day, there will likely always be a need to have some risk information “pushed” throughout many firms, but the ability for entirely separate, independent groups to dynamically “pull” data throughout an organization should become standard practice as time goes on. If nothing else, it should allow:

• Better integration of risk within the investment process (e.g., if fund managers can monitor their own risk, they should be able manage their portfolios in such a way that they can better justify investment decisions from a risk/return perspective)
• Improved dialog amongst teams (e.g., if a risk team, board, or CIO is able to monitor risk across portfolios, they can ask meaningful questions to PMs before risk becomes a problem)
• More frequent and timely dissemination of risk results internally and externally

The main takeaway from this section is the need to understand the means and options by which you can communicate analytics across the firm when you are working with your risk model vendor. Make sure that you have scalable solution that can grow as your needs grow and change.

I will be wrapping this subject up in the next installment.

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