Risk management is still a new concept in the alternative investment community, particularly in Japan. Unfortunately, there is no textbook definition of risk management just like there is no textbook definition of corporate management or fund management; which further complicates how risk management is implemented. These terms merely reflect the culture and philosophy of the management team, which uses its skills running a business. Risk management therefore reflects the culture of the company or fund that the management team has already established.
An MBA should equip an individual to manage a company just as a CFA equips a CIO to manage money. These academic and technical skills are sometimes viewed as pre-requisites for business and fund managers but they certainly do not guarantee satisfactory results. Likewise in risk management, there are now certifications for risk managers in the sell-side industry. But obtaining such a degree does not make a risk manager. The most important criterion for a risk manager is the ability to utilise his technical skills in order to serve the management team in accordance with the team's culture and philosophy.
From my career in risk management, I have identified the following main responsibilities of a risk manager:
- To be a "value-adding" resource for the management team.
- To increase the efficiency of the risk/return ratio for the organisation.
- To be the guardian of capital preservation.
- To be the credible source of information on global risk.
The first responsibility clarifies the confusion between the management team and risk management. I have often been told that the management team does not need a risk manager because the managers do an excellent job controlling the downside volatility of their product. A lot of talented people can certainly provide an excellent risk management job. However, most of the fund manager's time is consumed by investment decisions and marketing and as a result, he or she does not have the spare time to follow tedious and complicated risk procedures.
Someone who has experience in risk management should analyse and provide summary information on the fund's risk levels so the manager can more efficiently allocate time to investment activities. The risk manager's job is not to manage the portfolio's value, but to provide the current status of the portfolio given the historical and the predictable future courses of market moves. This could result in a useful model to stress-test the portfolio for future market moves, which would help the investment manager's decision-making process.
The second responsibility is closely linked to the first one, but applies more to complicated organisations. Instead of a single strategy fund, let's assume products with multi-strategies, funds of funds or diversified investment portfolios. In each strategy or at each sub-portfolio level, the responsible fund manager is managing multiple price risks and potential portfolio shocks.
At the individual investment level, risk control and optimisation of the risk frontier can be analysed and pursued. But this may not be the case at the aggregate portfolio level. This is a common challenge for large funds with multiple strategies and institutional investors with diversified investment portfolios.
It is hard to rank investment products by quantitative methods. Even if you are happy to use statistics to rank funds, the best performing product may not be the best choice for your portfolio since portfolio balance and the effect of newly added funds matter a lot. So you need to consistently test your portfolio against dynamic market moves and how the selection of new investment products affects your portfolio's overall risk/return ratio.
The third responsibility deals with a different time scale and mind set. For day-to-day investment activities, certain risk scenarios need to be scaled down. For example, what is the chance of North Korea launching a missile at Tokyo? If you are worried about this scenario today and spend all of your money on Nikkei puts, you probably have some information that most of us do not. Instead, most people put a certain probability on a scenario and scale the result accordingly. In risk management jargon, we call this Value at Risk (VaR). This is a very useful technique to aggregate the risks of different asset classes and even risk categories.
However, no matter which methodology of VaR calculation is used, it is only a scenario testing; and the scenario here assumes ordinary market moves. In order to complement this, many people may scale up the confidence level, extend the sample data or use stress-testing, which assumes extraordinary market moves.
Risk-taking activities are necessary in any business and some kind of quantification does help to make decisions. However, knowing the existence of risk against a certain scenario is more important than trying to improve the accuracy of its quantification. It is not the question of whether the stress-testing results are accurate or not, but whether the stress scenarios are useful in managing the portfolio. Such qualitative risk management over quantitative one should prevent unwanted risk-taking.
Finally, one of the most active risk management discussions in hedge funds in recent years concerns portfolio risk disclosure.
At publicly traded companies, the chief financial officers are responsible for disclosing credible financial data to the investment community. Many financial institutions have also created the role of chief risk officer - responsible for disclosing risk data to investors and regulators when requested.
For investment management firms, being able to provide credible risk data to investors could prove the firm's risk management capabilities and possibly save the fund from unwanted redemptions. Therefore, it is necessary to have an efficient risk management infrastructure including risk systems, which produce metrics that are easily promulgated to interested investors. By setting up such risk management infrastructure, challenges of the above-defined risk management can be satisfied by professional risk managers. The alternative investment community will not be satisfied with "Mickey Mouse" risk management reports created for regulated banks for compliance purposes. They demand it to be innovative and value-adding in accordance with their fund and investment cultures. This should be the way to go for risk management.
* Yoichi Umeki is a director of Asia-Pacific Consulting in Tokyo and represents SunGard's Reech products and services in Asia. He has been an active steering committee member of Tokyo Risk Managers Association and regularly participates in AIMA Japan activities.