Mitigation of Market Risk in Fund Management

To control and have methods to offset market risk is tough and complex. Fund managers cannot always fully estimate the impact of the market risk on their portfolios. 9/11 was an event that no one had ever envisaged. Yet, it happened, forever changing the way risk was viewed.

Tim East, the Director of Corporate Risk Management Services at The Walt Disney Co. says “First, 9/11 has made all of us more aware of the need to consider risks and exposures we've never considered before—to evaluate risk more broadly and to include the cascade effect of multiple events occurring at the same time.

Second, the resulting coverage and form dispute following 9/11 made it clear that risk managers, brokers and insurers need to get the terms, language and conditions communicated clearly and acknowledged by all parties.

Dan Kugler, the Assistant Treasurer, Risk Management at Snap-on Inc., while speaking about 9/11 opines, “From a risk-manager’s perspective, the events of 9/11 made me expand my view of “what can happen” and the resulting consequences—highlighting the need to expand our view of potential loss and the need to fully support and work closely with local officials in coordination of catastrophic losses.” Selective Hedging

Selective hedging is one of the ways used by fund managers to mitigate risk. Certain portfolios come with inherent risks that have to be taken on. A good example of this is a fund that invests in a certain sector the world over. This exposes the fund to risks due to volatility in foreign exchange. To hedge this forward currency contracts can be used. These contracts have to monitor the underlying asset values and roll overs must be done when required.

A fund manager may want to take advantage of interest rate changes in a bond portfolio. They will also seek to have higher immunity to changes in interest rates. One way to do this is to calculate first and second order derivatives of bond values, with respect to their yield to maturity. If we assume the same changes in yields across all bonds in a given portfolio, we can arrive at the portfolio value duration and value convexity by adding up individual bond durations and value convexities. This immunization works for small changes in interest rates.

A more value adding approach is to calculate each bond price variation relevant to each relevant interest rate movement and choose portfolio weights accordingly, to maximize on portfolio gain for the forecast interest rate movement, while immunizing it against other movements. Momentary Hedging

On some occasions of market fluctuations, fund managers will look at reducing some exposures. They may want to do this when they are pre-occupied elsewhere and need a short respite. If they close their positions it could prove expensive. An alternative is an overlay hedge which can be both less expensive and more efficient. This is done by adding off-setting derivatives, which will not off-set unwanted exposures but will help achieve a global hedge. This can be used only briefly during a market crisis where the correlation between market factors tend to increase. Risk Adjusted Performance Target

While pursuing a risk-adjusted performance target fund managers have to arrive at investment strategies and risk management strategies concurrently. Fund managers have to follow a policy that encompasses a level of diversification, leverage, selection of securities that are compatible with the objectives of investors and their own forecasts. Fund managers need to clearly state the quality of assets that they are going to invest in to prospective investors. This will indicate the volatility of returns. The degree of gearing of risky assets and diversification will decide the level of risk in the portfolio. A greater level of diversification or a portfolio with more independent securities helps reduce the total level of risk by averaging out independent risks.

When we allocate funds to a risky asset class relative to a risk free asset class, typically using cash deposits or borrowings to invest in the risky asset class than the equity value of the fund is called gearing up or leveraging. The expected return above the risk free rate and the volatility of return vary proportionately. Investors look for both attributes in tier search for a well-defined fund. Fund managers use heuristics to constantly balance their portfolios. They arrive at these by trial and error that combine objectives of profit with risk minimization. (Stop losses, delta limits, limits on turnover). Fund managers using systematic re-balancing rules use highly quantitative investment strategies. Capital Protection

Fund managers in their attempt to attract risk averse investors by making offerings that include participation in the high return risky asset classes such as equities and commodities fall in this category. Such funds promise a minimum return such as a capital guarantee or return on a low risk investment, such as a deposit or bond.

These are simple to manufacture, but have some constraints. They come in one fixed size and fixed maturity issue. Unlike open-ended funds they cannot be redeemed at any time. Compliance and Accountability

Investors are becoming increasingly discerning and keep an active eye on their funds. Fund managers must abide by regulations and caps, but they must also be sure to meet with the investment objectives of investors, while maintaining risk limits. Failure to do so results in investors suing the fund for negligence or non-compliance with fund policies.

Notable among these kind of situations is the case of Unilever superannuation fund vs Mercury Asset Management Unit of Merrill Lynch Investment Managers for poor fund performance. The fund was underperforming below the benchmark by about 10% for more than a year. The fund had promised to give returns over 1% over the benchmark with a tracking error of not more than 3%. Unilever sought 130 million pounds for non-performance. It was learnt that the fund manager had delegated the management of the fund to a junior officer and there were critical lacunae in the assessment and use of risk models. Eventually the two parties settled out of court.

Good funds consistently maintain the balance between high returns within prescribed risk limits. It is a complex task that requires a thorough understanding of risk models, market risks and an eye for opportunities for growth.