In asset management, nothing is more crucial than managing risks. In the past few decades mutual funds across the world have grown, managing nearly $87 trillion (about 75%) of banking assets. This could not have been achieved without a thorough examination and assessment of various kinds of risk.
While the asset management industry is exposed to several risks—each critical—none is greater than the risk of loss of reputation. For any asset management company (AMC), investing people’s money is a matter of building a track record of good investment practices, careful selection of investments in quality assets while optimizing the returns generated. It is very crucial, therefore, that the AMC has strong risk management practices.
Banks and AMCs compete for the same funds. But unlike a bank, where investment mistakes may show up gradually and recovery is possible over time, AMCs do not have the luxury of mistakes. Such errors instantly reflect in a fund’s falling net asset value (NAV), and can hamper the growth of the AMC. Besides, when there is a severe cash flow crunch, mutual funds are subject to liquidity shocks. Hence, AMCs are exposed to a significant downside if they err in the investment process.
Types of risks
For an investor, the greatest risk, as succinctly put forth by the father of value investing, Benjamin Graham, is the permanent loss of capital. In market parlance, risk is measured by volatility, that is, the change in price of an asset. The bigger the movement in the prices, the greater is the risk.
Generally, large AMCs have a dedicated team of risk managers, who oversee the portfolio risk. They are independent of the investment teams and help in evaluation of the portfolio against risk parameters.
AMCs strive to analyse all types of risks—credit, market, operational, liquidity, regulatory, and so on. Credit risk is the risk of a decline in creditworthiness of the borrower or defaulter. Market risk is the change in prices including interest rate and currency risks; operational risk is the loss due to a failed process; liquidity risk is the lack of saleability of an asset; regulatory risk the change in regulations affecting a stock, sector or fund.
Risk management process
To manage risk, one has to measure it. The problem is that while some are easily measurable, some are not. Holistically, while volatility risk can be measured; often event-related ones cannot be.
As part of risk measurement, AMCs endeavour to forecast the future state of variables. Tools such stress testing a portfolio and scenario analysis are regularly used to assess the potential impact on a portfolio in times of extreme volatility.
Risk managers also keep a regular tab on key macroeconomic variables, e.g., money supply, inflation, movement in investments by foreign institutional investors and event risks that can have a bearing on a fund.
Investment risk in funds is key
The investment risk of a portfolio is also driven by the mandate of a fund—the nature or type of assets it invests in. Investment risk is typically addressed by stipulating limits on exposure to sectors or stocks. Thus, the fund managers are not permitted to cross a threshold.
While there is no concept of default risk in case of equity funds, they are exposed to other risks. And those are fund structure risk (open-ended funds would inherently have higher sensitivity to redemption pressure), fund capacity risk (evaluating investment opportunities in relation to the market volume, particularly in thematic and sectoral funds), correlation risk (how an asset price moves against another investment. A negative correlation may eat into the fund’s value, while a highly correlated portfolio may not entirely reflect diversification benefits), and so on.
Counter-party credit risk is relatively lower in case of debt funds (which primarily invest in extremely liquid money market instruments and government securities). Such investments, however, are exposed to interest rate risk. Compared with debt funds, credit funds assume a relatively higher counter-party credit risk. Skewed return profile (a cap on the potential upside) makes it imperative that the investments justify the risk return trade-off. Funds tend to address counter-party credit risk through proper client selection, adequate security and tighter monitoring. Credit funds are also exposed to increased liquidity risk as liquidity of instruments issued by corporate entities may be lower compared with government securities.
Other risks relevant for asset managers
Redemption risk is faced by all funds, equity or debt, from time to time. Funds may be suddenly faced with severe redemption pressure, as was evident during global financial crisis of 2008. During such an eventuality, a fund may then have to liquidate its investments at distress prices, very often at a loss. Funds manage redemption risk by monitoring redemption requests and holding adequate liquidity. Funds also tend to impose exit load to assuage the impact of redemption prior to the stipulated period (while preserving the investor’s right to redeem).
Consistent application of valuation methods ascertaining the fair value of the investments, while remaining compliant with the applicable regulatory and accounting standards, is key to managing valuation risk.
In short, an AMC has to evaluate and monitor all these risks on a continuous basis. This can only be done by instituting sound systems and proper processes, and strictly adhering to them. Though risk cannot be completely eliminated, some of it can be controlled.
Asset managers need to prudently manage risk in their fiduciary capacity. The delivery of high quality asset management services requires rigorous risk management practices, including taking an enterprise-wide approach to it. For investors, they need to be aware of the fact that they should not be selecting asset managers purely on the basis of returns generated from the schemes invested. Instead, they need to prefer asset managers who are committed to risk management.
This article was published in Mint on 7th October on page 20.