Originally published December 12, 2005

 NEW YORK — Asset managers are placing increasingly more importance on improving risk management techniques, not for regulatory reasons, but in their quest to fine-tune investment products by adding absolute-return offerings. Investment managers are moving aggressively into more automated and real-time risk analysis. In addition to identifying business risk, they seek to support investment decision-making as well as settlement and processing systems for complex instruments, especially credit derivatives, says Edward Hawthorne, Managing Principal at Capco’s advisory services group, who works with traditional and alternative asset managers.

The following trends are driving a new convergence of sell-side capabilities, technologies and strategies with the buy side, according to Hawthorne:

• Lackluster performance for the past five years.
• Pressure on fees charged for various active products.
• Flat growth for earnings on assets, even though assets under
  management have grown.
• Demand from institutional investors for sophisticated and flexible strategies that deliver better returns.

Traditional asset managers increasingly are choosing to address demands of institutional clients (and their own objectives) to improve margins by delivering more hedge fund or absolute-return strategies, which attract higher fees and often have performance fees. Kelsey Biggers, Managing Director, Risk Management, at K2 Advisors LLC and founder of Measurerisk, a Web-based service that provides risk analysis to institutional investors, underscores the importance of risk management in the hedge fund business. “Risk management is virtually central to hedge fund investing,” he says. “You can’t manage returns. You can only manage risk.”

As a hedge fund-of-fund management firm with $1.4 billion in assets under management, K2 looks at more than market risk, according to Biggers. “We look at reputation risk and operations risk and broader things that can go bad, hurting our investors or our franchise,” he says. “We need to look at risks individually for the individual managers. As a fund of funds, it is very important to look at all our managers in aggregate. The aggregate portfolio risks are very important to us in constructing portfolios. Risk management plays a role in portfolio construction as much as monitoring managers.”

Using over-the-counter (OTC) derivatives or structured products makes hedge fund investing more difficult, according to Biggers. “Those are hard to value and harder to model,” he says. “Those are also areas where hedge funds find opportunity. Such instruments are tailored or customized or provide return opportunity, but are also more opaque. So it is incumbent on the fund of funds or the hedge fund investor to work harder to understand how those work, without limiting the options that our hedge funds have in how they invest.”

Many managers use an order management system (OMS) for traditional product offerings and then bring in a middle-office tool to support the hedge fund product with a different investment view. An OMS consolidates trading desks for a range of products, but is less useful for credit derivatives and determining risk through filtering and scenario analysis, according to Capco’s Hawthorne.

An OMS can be powerful in investment guidelines screening, but not all strategies require this screening, adds Hawthorne. Systems helping managers assess credit-derivatives risk do not work as trading systems, but mediate between trading algorithms and supporting such algorithms for hedge fund strategies, assessing the risks in portfolios, settlement and order capture along the way. Institutional clients want strategies that are not correlated with their beta investments, but have the potential of delivering higher returns. “We are seeing an emerging requirement for what is often called a middle office on the sell side to support trading desks with close to real-time risk reporting and scenario analysis,” says Hawthorne. “It is a view of risk that supports the investment-decision process as well as the operational complexities of settling and clearing, and further processing of these investments.”

Investments in various credit products can require a lot of paperwork and manual activity and can result in a delayed view of risk, affecting investment decision making. “It is also very costly,” says Hawthorne. “Many on the buy side are beginning to invest in systems and skill sets to help them with this middle office.” Investment banks’ asset management divisions are notable users of these middle-office systems, leading the move to more sophisticated strategies, including hedging.

Prominent providers of middle-office systems include Calypso and Murex, which offer flexible, integrated products. Calypso Technology, Inc., of San Francisco, offers cross-asset front-to-back trading and trade processing solutions. Paris-based Murex offers MX Asset Management, a portfolio management, trading and straight-through processing system for asset managers. In addition, Advent Software, Inc., addresses the needs of hedge fund managers.

Paris-based provider Sophis offers cross-asset class and fully integrated portfolio and risk management solutions. Its VALUE comprehensive front-to-back system is aimed at asset management companies. “When you have market data and a valuation model, the additional effort to run value-at-risk is minimal,” says Emmanuel Fruchard, Director Fixed Income, Credit Professional Services, at Sophis. “Customers can be sure that there will be no problem in transferring the trade and in recreating a full environment in VALUE, where they can run risk management analytics.” Sophis worked with AXA Investment Managers in Paris on development of VALUE’s fund and risk management solution for the buy side. “They have a culture of customizing a lot in house,” says Fruchard. VALUE has all the features and functions AXA needed, but AXA can replace parts of the system with its own models. AXA sought to price and calculate returns and risk for all its products, adds Fruchard.

Independent and boutique hedge funds joining larger organizations are driving technology decisions. Sell-side talent moving to buy-side firms want the same systems capabilities they had, according to Hawthorne.

In credit derivatives, prominent sell-side provider Calypso is also now serving buy-side needs. “One trend is increased use of credit derivatives by real money accounts and inability of their current infrastructure to support that activity,” says Mas Nakachi, Senior Analyst at Calypso. Calypso has several hedge fund users focusing on credit derivatives and cross-asset class capabilities and the numbers of such users are growing, according to Nakachi. “Currently, the focus is on dealing with credit derivatives on a full, front-to-back, STP framework. That can then be expanded to support general derivatives activities.”

Institutional investors can run their own integrated portfolio analysis and risk reporting. Institutions need integrated systems that can provide portfolio-specific views of concentration, market risk and credit risk, and also overall portfolio risk, according to Hawthorne. This requires a robust integrated platform. What is important is that the total business-wide view of risk requires a system or in-house platform, he says.

In recent years, when investment management firms — such as Janus Capital Funds and Putnam Investments — faced business concentration risks, their growth and profitability depended on active equity products focused on technology stocks, according to Hawthorne. If those products failed, their businesses suffered. Hawthorne finds it strange that asset managers spend time educating clients on the benefits of diversification, yet don’t have a diversified product stream themselves. Through various derivative instruments and the loosening or broadening of investment strategies, asset managers have more ways to isolate and pinpoint the risk and return of potential investments.

The Calypso system’s risk aggregation tool consolidates heterogeneous systems. For example, Calypso offers a solution for an investment bank using a legacy system for a fixed-income product. As the bank starts trading credit derivatives, it recognizes a need to see risk across bond trading and derivatives, and purchases Calypso. The market is moving toward greater use of credit derivatives, according to Nakachi. “Looking at siloed data, investors may have long credit derivatives group risk and short credit risk in another group, not knowing that these are averaging out,” he says. “They could also be long in both and not know that they were doubly long in a particular risk.”

A risk aggregation system can also alert users to holdings in firms currently in bankruptcy proceedings. “They could have an exposure to Delta, for instance, buried in the firm’s credit derivatives or cash bond areas,” says Nakachi. “Unless the user is looking at them together, that exposure may be missed.”