Q&A: Dr. Paul Magro, RiskCap International
Dr. Paul Magro, Founder & Managing Director of RiskCap International, discusses developments to outsourcing investment fund risk.
AW: Paul, when investors screen hedge funds for an allocation, it’s arguably as much about risk management as returns. What developments are you seeing in portfolio analysis and management?
PM: Following the financial crises over the past 2 decades the hedge fund industry has seen a shift from traditional high net worth investors to institutional investors. These new power allocators sought strong risk management, tight operational controls, and robust compliance policies and procedures. Operational due diligence is deemed crucial especially in the post-Madoff world. This combined with a raft of post-crisis regulations, barriers to entry went up and the costs of operating a fund rose correspondingly has changed the perception that portfolio related metrics will only get you to the door with an investor. Therefore, without the proper investment in an operational infrastructure will not get the fund manager anywhere as nowadays investors spend significantly more time reviewing the operational infrastructure set-up by the fund manager.
When it comes to portfolio/ risk management, regulators and investors are demanding greater transparency and accountability. Many managers fail to win investment allocations, as they may have a good performing fund and cover the operational questions of their fund but if they cannot show an in depth understanding of their investment strategy and be familiar with the associated risks like a 3rdparty issuer/counterparty risk, stress testing and liquidity in general. Then they will find it far harder to win as there will always be other competing funds out there, who can answer all these questions.
AW: Risk management isn’t just about VaR; it’s the entire infrastructure of the firm. New hedge funds face higher cost hurdles than ever before when starting out. What are some of the benefits to outsourcing risk management?
PM: Value-at-Risk (VaR) in the past has been associated more with the sell-side rather than with the fund industry (buy-side). It has gradually made its ways into the hedge fund industry and is a useful tool when assessing market risk. However, it is correct, to say that risk management isn’t all about VaR. In today’s world, for fund managers to attract institutional investment they are required to show that they have in place a robust operational infrastructure. This includes a risk management framework. Having good returns is attractive but, in the end, the institutional investor’s focus will be on the overall operational infrastructure implemented by the fund manager. The challenge of running a fund today is managing expectations vis-à-vis the costs of running a fund. It is important for fund managers to assess and compare the marginal cost of adding the necessary infrastructure with the marginal additional revenue associated with having this infrastructure in place.
The benefits of outsourcing your risk management, to a firm such as RiskCap, include: -
- Financial benefits that allow fund managers to optimise their cost base;
- Enhanced flexibility in operating models that lead to economies of scale for fund managers;
- Independence from internal and external pressures;
- Adopt best practices in accordance with international and regulatory standards;
- Cross-jurisdictional experience;
- Use of market leading risk analytics systems and professional risk reporting.
AW: Some hedge funds use outsourced risk providers as a second opinion. Is this a trend that you see continuing and why?
PM: Indeed, this a trend that we are seeing but not necessarily as a second opinion. Outsource risk providers can assist fund managers on multiple fronts, this include the day-to-day monitoring and reporting of risks to portfolio managers and risk managers in fund management companies. RiskCap is engaged with fund managers in Luxembourg, Ireland, Malta and the UK to assist fund managers with the day-to-day monitoring of risks and reporting. This offers fund managers and investors comfort that a third party independent of the fund manager is monitoring and reporting back to management on the risks that materialise in the portfolio.
AW: Independence has become an essential part of a fund’s board of directors. What are some of the trends you’re seeing here?
PM: Independence is key today. In the past a fund’s board would be made of members of the fund manager and/or associations of the fund manager. The question of director independence has been at the heart of corporate governance discussions following a number of fund defaults and the financial crises. The presence of independent non-executive directors is widely considered as a means of protecting the interests of shareholders and other stakeholders. Increasingly we are seeing fund boards including independent directors. This a step in the right direction because by appointing a director (or directors) on the board who are free from material conflicts of interest, will ensure appropriate scrutiny and challenge of fund manager recommendations and proposals and, when appropriate, for these directors to make objective decisions which may be in conflict with the interests of the fund manager.
AW: Finally, Paul, what advice would you give to new hedge funds starting out with regards to a holistic approach to risk?
PM: All Start-up and emerging fund managers wanting to succeed need to realise that running a hedge fund is managing a business. There are various solutions in the industry that would allow a new hedge fund to launch without the hassles of managing the business side of things. However, if a fund manager is to go at it alone, the fund manager needs to be aware that the operational aspect of running a hedge fund is even more important today than is the performance. If a fund has a very good performance but does not have the operational infrastructure there may not be any chance for growth. Six months ago, I was having a coffee with start-up fund manager in London discussing the importance of having a robust operational infrastructure including a risk management framework and how investors will focus heavily on this area. The gentleman felt that it was too early to be thinking about risk management. A few days ago, I received a call from the gentleman telling me about his experiences with investors where the focus of the meetings with them is on the operational infrastructure, namely, risk management, compliance, staff policies and procedures. That it is difficult for investors to invest without thinking about the broader picture of running a business rather than focusing on performance returns.
Dr. Paul Magro is Founder and Managing Director of RiskCap International
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