RISK MANAGEMENT: Changing relationships

In recognition of the AIFMD, Nicholas Pratt reviews the major risk systems available to alternative managers and the ways they can help firms to meet the directive’s risk management requirements.

The alternative investment Fund Managers Directive (AIFMD) may have started life as one of the more contentious regulatory initiatives of the post-crisis financial world, but with the implementation date of July 2013 almost upon us, the oppositional attitude that greeted the initial announcement has largely faded.

Now the focus is on ensuring that all of the directive’s requirements will be met before the deadline of July 2014.

The 18-month legislative process has seen the perceived flaws of the original text amended and an EU passport made available to jurisdictions outside the EU so it is now possible to view the directive’s  objectives more clearly and not as a politicised reaction to the financial crisis. In short, the European Commission has not gone as far as expected in its finalised text – be that the limits to delegating investment activities or the expanded liability for depositaries.

The AIFMD will, however, change the relationship that hedge funds have with some of their service providers. Depositaries will have an auditor-like role in relation to a manager’s activities, such as the power to access a manager’s books or make on-site visits, or even issue warnings should the segregation of assets be under risk. Another changing relationship will be that between the manager and the provider of their risk technology.

One the primary objectives is to give supervisors a tool to monitor systemic risk within the alternative investment world. More specifically, the directive is aimed at those alternative investment fund managers not previously subjected to regulation and will be required to create risk management functions that are independent of portfolio management and are capable of providing risk managers with the ability to review risk across the investment process and introduce any necessary risk controls. In short, risk managers must be seen to be empowered and independent.

According to a report published by PricewaterhouseCoopers in 2012 entitled Building AIFMD risk structures in a Euro storm, the risk management requirements of the AIFMD are far more of a “revolution” for the alternative investment sector which previously faced no risk management regulations when compared with the “evolution” of Ucits risk guidelines. “Applying a broad set of risk management principles to all alternative investment asset classes, the AIFMD requires managers to re-evaluate how they control risk.”

The risk requirements can be divided into six categories – function, policy, limits, monitoring, reporting and testing. These processes must be applied to any material risk the fund is exposed to covering at a minimum, the following risk categories – market (including leverage), credit and counterparty, liquidity and operational. The calculation of a fund’s leverage will be a core requirement, as will the regular production of a liquidity report for each fund. Finally, the manager must be able to describe the processes they have put in place and provide reports across a range of parameters including the type of assets, risk profile and any risk systems used.

This last point regarding risk systems is especially important in the context of this year’s Funds Europe risk survey which has focused specifically on systems available for alternative investment fund managers.

A 2012 report from BNY Mellon, Risk Roadmap: Hedge Funds and Investors’ Evolving Approach to Risk, surveyed chief risk officers at hedge funds as well as investors, prime brokers and hedge fund consultants. It shows that 79% of firms already separated their risk management and portfolio management functions and 84% of hedge fund managers enhanced their risk systems through the purchase of third party, off-the-shelf risk systems. But the report adds that “more is needed to better model more complex multi-asset, multi-strategy portfolios. (Hedge funds) can no longer use yesterday’s analytics in today’s environments”.

Meanwhile, the PwC report set the AIFMD risk management requirements against the backdrop of the eurozone crisis that enveloped much of 2012, therefore underlining the importance of stress testing and scenario modelling and emphasising that while compliance with AIFMD is important, risk management is something more significant than a regulatory requirement.

There is further evidence that the hedge fund industry is embracing risk management and transparency regardless of the AIFMD. Figures for 2012 from the Global Hedge Fund Industry Report, produced by US-based Hedge Fund Research (HFR), showed that the total industry capital for hedge funds rose by $60 billion (€45 billion) to a record $2.25 trillion in the fourth quarter of 2012. Furthermore, when looking at capital inflows by strategy, fixed income-based relative value arbitrage (RVA) funds led the way with a $6.5 billion increase in the fourth quarter bringing the year’s capital inflows to a total of $41.4 billion and an overall capital of $609 billion.

According to Kenneth J Heinz, president of HFR, the rise of RVA funds and the proliferation of Ucits-compliant hedge funds reflect a “significant and fundamental shift” in the hedge fund landscape and a desire to meet investors’ demands.

“Investor preferences have moved away from opaque, black box, illiquid and high equity market beta strategies and have moved to embrace high-quality strategies offering transparency, liquidity, tactical flexibility, strategic innovation, accessible account minimums, consistent performance gains and institutional risk management.”

All of which suggests that the take-up of risk systems among the alternative investment community should be set to increase, be that large hedge funds and long-time users of third-party risk systems looking to acquire more services or greater functionality. For example, BlueBay Asset Management’s purchase of real-time risk management services from Imagine Software for its alternative investment desk. Or the smaller boutiques swapping in-house developed risk systems for an off-the-shelf alternative .

The seven vendors featured in this year’s survey have products that cater for alternative managers. The functionality offered by the majority of systems in the survey is broadly similar. All risk types are catered for, as are most fund types. There is a recognition of the different level of operational resources at many alternative managers given that so many of the vendors offer products that can be delivered in a hosted format.

The offerings from two of the largest risk vendors, IBM Algo Risk Service on Cloud and SunGard’s Hedge360, both emphasise the importance of hosted delivery platforms. Other vendors have focused recent development on enhancing their reporting capabilities and providing more sophisticated stress-testing services – two areas that will be especially important once the AIFMD regime comes into force.

©2013 funds europe



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