Risk Management: Some Basics

Dr. Philippe Jorion of the University of California at Irvine and Managing Director of Pacific Alternative Asset Management Company (PAAMCO) wrote a main portion of the risk management overview for the CAIA Level II curriculum.  There are market, credit, liquidity, regulatory and counterparty risks.

Market risk is the risk of loss in financial market prices.  It is also called systematic risk.  To calculate market risk, all the assets in the portfolio should be used to find the possible profits and losses by using market data.  The most well-known model is value at risk (VaR).  This allows for tracking of any drift in investing style, hidden risks and of new fund managers, markets and assets.

Credit risk is the risk that a counterparty to a contract does not fulfill its obligation by not paying the amount or not delivering the asset owed.

Liquidity risk occurs when an investor cannot sell assets.  There are two types:  funding and asset.  Funding liquidity risk happens when investors redeem their capital from a fund, when loans from the prime broker are not renewed or during margin calls.  In these situations, the fund may be forced to sell assets to raise capital.  Asset liquidity risk is the risk of losses due to the price impact of forced asset sales.  These risks can be mitigated by matching the investment horizon of an investor's assets and liabilities, putting in place a lock-up period when an investor cannot redeem their capital, having a notice period before redeeming capital, creating gates to limit withdrawals to a percentage of capital and suspending redemptions altogether.

Regulatory risk is the risk that government or regulatory agencies may change the financial rules such as imposing short stock trades during the credit crisis of 2008.

Counterparty risk is almost the same as credit risk except it includes the counterparties of your counterparty.

We will be examining other topics from Dr. Jorion's writings in later posts.  The source for this article can be found here.

2011 Investment Outsourcing Round Table

Pensions & Investments published the transcript for the 2011 Investment Outsourcing Round Table that was held on June 1st.  There were six participants from different roles in the investment community.  They were:

• Christopher Delany - associate treasurer in finance and administration at Gettysburg College
• Jay Gepfert - senior consultant at New England Retirement Consultants LLC which evaluates investment outsourcers for institutional investors
• Jonathan Hirtle - CEO of Hirtle, Callaghan & Co. which manages $20 billion in portfolio outsourcing strategies
• George Mateyo II - senior director of investments at the Cleveland Clinic Foundation
• R. Bruce Myers - managing director of consultant Cambridge Associates LLC which manages $105 billion in outsourced strategies
• Kevin Quirk - founding partner and principal of Casey, Quirk & Associates LLC, a money manager consultant

Some interesting ideas discussed were:

There is a movement towards outsourcing as an investment solution because of poor performance in the equity and bond markets, increased demand for alternative investments and institutional investors spending less money and time on managing their money.  Outsourcing has traditionally been confined to the worlds of pensions, endowments and foundations.  Corporations with defined contribution plans (i.e. 401K's) are starting to look at outsourcing to protect themselves against fiduciary risks.

Delaney at Gettysburg College decided to partially outsource the university's endowment.  The college defined the responsibilities of the board, employees and the consultant based on where everyone would add the most value.  The consultant would have access to the best fund managers.  An analysis was done by Delaney to determine where each person would be comfortable and keep those responsibilities.  Any weaknesses would be outsourced.

The current investing environment needs to have disciplined portfolio management across all asset classes.  Currently, the fund industry is based on where the manager invests and the benchmark for that universe (the performance of large cap managers are compared against the Standard & Poor's 500).  This started in the easy investing decades of the 1980's and 1990's.

Outsourcing also has conflicts of interests that need to be avoided.  Consultants that are paid fees by fund managers, paid soft dollars because they are broker/dealers and paid by manager search.

The source for this article can be found here.

Commodity Funds: Best Performers for the Second Quarter

There was a sell-off in commodities in early May causing the average commodity fund to fall 5.12% for the second quarter.  The best commodity fund was up 6.8% in the same timeframe.  Obviously, it was a short fund - PIMCO's CommodityPLUS Short Strategy.  This fund bases its portfolio on the Dow Jones - UBS Commodity Index and takes the opposite side of the trade.  Other strong performers were gold and market neutral funds.  In fact, seven of the top ten best performers of the quarter were gold funds.  They invest in gold buillion, futures and miners.

The source for this post can be accessed here.

Basel III Effects on Shadow Banking

What is shadow banking?  The Financial Stability Board said there is no common definition in its Shadow Banking:  Scoping the Issues.  It tries to define it as "lending by any organisation outside the regulated banking sector that creates systemic risk or opportunities for regulatory arbitrage, particularly if long term assets are being funded by short term liabilities, and those assets are securitised and/or re-hypothecated."  This is close to the prime brokerage model for investment banks.  Here banks use the repo markets to fund themselves on a daily basis, using the assets (securities and cash) in the prime brokerage accounts of hedge funds as collateral.  During the crisis of 2008, Bear Stearns, Goldman Sachs and Morgan Stanley could not fund themselves because hedge funds moved their assets from the banks.  Because of the lack of collateral, the repo markets and daily funding, were diminished for them.

Basel III, the new global regulatory standard, will set tighter liquidity and capital ratios for banks.  Banks are also divesting their proprietary trading desks.  These changes will lead to an increased cost of funding for prime brokers and, therefore, for hedge funds as well.

The source for this article can be accessed here.

European Debt Crisis: Some Investment Approaches

Several hedge funds are predicting that the European debt crisis, currently centered in Greece, will spread to Portugal, Spain and Italy and are executing that investment thesis in different ways.  CQS UK is approaching it not by shorting government debt or buying credit default swaps but by trading corporate debt of discretionary spending such as mobile phone companies or of government subsidized enterprises such as utilities.  Marathon Asset Management is expecting the sovereign debt and financial institutions of Portugal, Ireland, Spain, the United Kingdom and Italy to run into trouble.  The banks are overleveraged and will have to be nationalized.  Groveland Capital is buying credit default swaps on Italian and Spanish government bonds because they are a better value than Portugal and Greece at this time.  It's too late to make money on them.

The source for this article is here.

Best Practices for Hedge Funds: Investor Preferences

In May 2011, the Alternative Investment Management Association (AIMA) released a paper:  A Guide to Institutional Investors' Views and Preferences Regarding Hedge Fund Operational Infrastructures.  There are five sections, each authored by an investor, and AIMA compiled their ideas.  The topics are Governance, Risk, Investments, Capital and Operations.  Below are some topics of interest that I found striking:

Good governance should handle any conflicts of interest between the fund manager, board of directors and the investors.  Investors should be allowed to buy shares and have voting rights similar to a publicly traded corporation.  The board would have increased duties:  managing service providers (including the fund manager) and valuation.  The board should be composed of three to five directors with a majority of them being independent.  The directors should meet quarterly.

Risk reports should be sent on a monthly basis.  The other sections:  portfolio, operational, counterparty and liquidity held no surprises.

In the investments section, investors should be able to redeem their investments within a year.

Capital and operations sections held no new concepts.

Managed Futures Are Predicting Stock Market Downturn

Managed futures funds are run by Commodity Trading Advisers that use predominantly use trend following trading strategies.  The charts of the Barclay and Newedge CTA indices are predicting a downturn in equities in the near term.  After the Barclay CTA Index traded in a range in 1999-2000 and 2006-2007, the Standard & Poor's 500 Index collapsed.  There was another period in 2009-2010 and the market has been trending down.  Looking at the daily Newedge CTA Index chart, there was a recent drop of 5%.  This is presaging a drop in equities.

The source for this article written by Thomas Lott, President of Potomac Portfolios, with charts, can be found here.