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Buy-side vs Sell-side Risk Management

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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  1. Buy-side vs Sell-side Risk Management Philip best 11th November 2008

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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

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