Reducing the risk burden

UCITS III has the potential to transform the investment management environment across the European continent. Tim Wilding, Head of Research and Development at EM Applications – a leading supplier of investment risk solutions to asset managers and securities firms – explains why.

FST. Firstly, can you outline some of the threats and opportunities that transition to the UCITS III rules is likely to create?

TW. Over the last decade or so, we’ve seen a dramatic growth in mutual funds that do not have regulatory permission to be marketed to the European public – more commonly known as ‘hedge funds’. The theory was that without this permission, hedge funds would stay on the margin. In practice, however, hedge funds found that the advantages of a greater investment freedom – in particular the ability to invest freely in derivatives – outweighed the disadvantages of not being able to market to the public.

UCITS III is a recognition that investment in derivatives can be suitable for publicly available mutual funds. Traditional managers must be given the opportunity to invest in derivatives or else wither on the vine, as hedge funds take an increasing proportion of their territory.

The opportunities are quite clear; UCITS III gives traditional fund managers the opportunity to create publicly available mutual funds that invest in derivatives and simulate certain hedge fund strategies. Meanwhile, hedge funds now have the opportunity to package up some of their products and sell more easily to the public. Those opportunities, of course, also represent risks in that, if a competitor takes up one of these opportunities, it is potentially a threat to another firm’s business.

FST. So what best practices would you advise for organisations to deploy in order to survive and prosper in the UCITS III world?

TW. I think that is a very important issue and it will focus, in particular, on the whole area of product development. By allowing a much wider range of investment strategies, UCITS III provides product developers of fund management firms a whole new host of opportunities to create funds that meet particular investor requirements. For example, for investors seeking to make significant capital gains, UCITS III makes it possible to produce funds with gearing, not directly through borrowing, but through the use of derivatives.

Many investors, meanwhile, are looking to gain equity market exposure but with reduced downside risk. To reduce any risk, some upside must be given away but, nevertheless, the use of derivatives does offer the opportunity to control downside risk at a reasonable cost. However, to make use of these development opportunities, a product developer must have a good understanding of how derivatives and traditional transferable securities work, as well as the necessary expertise in terms of understanding client needs. The key best practice issue for organisations seeking to prosper in the UCITS III world is, therefore, product development teams staffed by individuals adept in these various areas of expertise, supported by appropriate systems.

FST. Are you optimistic that organisations will be able to meet the compliance needs before the deadline of February 2007?

TW. Yes, I don’t think it will be a problem, because conversion to UCITS III, in itself, places very limited requirements upon firms. Companies are free to not take up the new opportunities offered by UCITS III. The risk of not doing so is a competitive rather than a compliance risk. On the other hand, there are plenty of risk-management software vendors and consultants that will help them to convert. I feel for the regulators who, it would appear, are going to be swamped by a multitude of fund conversions in the final months of this year.

FST. The EU has left a significant degree of freedom to individual jurisdictions when it comes to calculating value at risk (VaR). In your opinion, what method of calculating VaR is likely to emerge as the best?

TW. Actually, my sincere hope is that a consensus doesn’t develop over which single method of calculating VaR is best. My personal belief is that the best way to calculate the risk of a portfolio varies with the nature of the portfolio and with market circumstances. Consequently, over time, I would hope that the regulators give firms more freedom to determine exactly how best to assess the risk of a given portfolio.

The one area where I believe a degree of standardisation may be of benefit, and that would give firms a good degree of comfort, is if the regulator were to define which market outcomes should be stress-tested for any portfolio. A great difficulty for product developers is that, in extremis, almost any investment product could cause investors to lose a significant portion of their capital if one makes sufficiently pessimistic assumptions. This can make it very difficult to manufacture and market what most experts would agree were genuinely low-risk products.

For example, consider the case of Barings, which could have been a counterparty to a derivative contract backing a low-risk investment portfolio. Before the company went bankrupt, any investment professional would not have regarded it as imprudent to have a counterparty exposure to Barings. However, had one done so, the maximum exposure allowed by the regulations of 10 percent could potentially have been lost in one day. Clearly, a low-risk product that had Barings as a counterparty would not have appeared low risk on the day that it lost 10 percent of its value due to Barings bankruptcy!

If a stress test assumes one of the counterparty’s bankruptcy, it then becomes impossible to make it low-risk, even though in truth the probability of another Barings is so small it should be possible to ignore it. What I would like to see, therefore, is the regulator define the different markets scenarios against which the fund management firm should test its products. How the fund behaves in these circumstances would then feed into the description of its risk profile.

This is akin to the situation in the automotive industry, where a car company has to put a new car through a precisely defined set of crash tests before it can be sold to the public. Car companies are not expected to imagine the worst case scenarios, because no car could be designed to survive every possible situation. It is exactly the same with investment funds.

FST. There are the discrepancies in the way different jurisdictions require VaR to be calculated. What problems is this likely to cause?

TW. The problems occur on two levels. On the one hand, it is very problematic for the risk manager, because he has to understand the nuanced differences between different regulatory approaches, and develop risk measurement processes and controls accordingly. On the other hand, it means there is no level playing field as far as risk management is concerned for investment funds domiciled in different jurisdictions.

Of course, in theory, a fund domiciled in one country must be approved for sale in another EU state without the host state regulator imposing a new rules. However, the very existence of different approaches to risk means that, unless the company entering the foreign market complies with the local approach, they may find it difficult to get market acceptance.

FST. When considering VaR, how do the concerns of banks and asset managers differ? What will the consequences of these different requirements be?

TW. The key difference is that the banks have their own money at risk, whereas investment managers have their customers’ money at risk. In addition, whereas banks must meet a capital requirement on a daily basis, so the time horizon is very short, contrast investors in mutual funds are advised to consider their investments for the long-term, and so have multi-year time horizons. This means that all the bank needs to know is how much money it might lose tomorrow, whereas a fund manager needs to understand the risk profile of a mutual fund over both the short and the long-term to ensure it can be correctly described to investors. In addition, it needs to be able to characterise the risks in order to confirm that the portfolio is being managed in a manner consistent with its mandate.

Clearly, the system needs of the two are very different, although it appears that in framing the UCITS III rules, the EU was thinking more of banking needs than of investment management needs. This places a burden on fund managers to develop and implement risk measurement systems that are possibly more appropriate in a banking environment, while still continuing to need more fund manager oriented solutions.

FST. What positive and negative impact do you think the new MiFID directive is likely to have on firms in the area of investment management and risk measurement?

TW. MiFID intends to clarify the responsibilities of the home state, where a fund is domiciled, and the host state where it is sold. To the extent that this initiative is successful it is likely the mean more cross-border competition for investment management firms. We would expect this to benefit firms that can demonstrate more expertise in fund management and those that can demonstrate more sophisticated product development. In both of these areas we would expect a premium to be placed on a firm’s ability to manage and risk control derivatives.

FST. How important is it that financial institutions have in place effective risk management to address the compliance challenge?

TW. We see it is vitally important, as this is likely to be key for success in the post-UCITS III mutual-fund environment. If a firm does not have an appropriate risk management process in place it will be consigned to managing funds which – although most likely over time, rather than immediately – will be regarded as dated in the use of modern investment techniques. While long-only funds will not die out and there will continue to be great opportunities for managers able to outperform market benchmarks, we are confident that an increasing proportion of the growth in assets under management will go to managers and funds that seek to deliver investments tailored to particular client requirements. This will mean funds with strategies that aim in some way to modify the risk return profile, which is likely to require derivatives and risk management.

FST. What considerations should they take into account when implementing a risk management solution?

TW. Obviously, every company is different and it will have its own particular set of requirements. But I think a key issue, which will apply across all but the very largest firms, will be to look for a solution that has a relatively low total cost of ownership. The practical reality is that risk management systems place a time cost on the risk personnel charged with using them. Portfolio data needs to be input in a certain way and the outputs need to be understood, not just reported on. Consequently, to the extent that a risk management solution can meet the regulatory and client reporting requirements across a fund manager’s whole range of funds, they will be a significant advantage in reduced learning and understanding time cost.

Similarly there is a considerable advantage in acquiring a packaged solution, which will typically be easier to integrate and where the bulk of development costs can be spread across many users. In summary, the solution should be able to do pretty much everything you need out, of the box, but without the need for teams of IT professionals to install or maintain it.