Practical Risk-Adjusted Performance Measurement. Carl R. Bacon
ranked in my priority order of concern at the point in time I assumed the role of Director of Risk Control at an asset management firm in the late 1990s.2 What I didn't appreciate fully then, but appreciated much later, is that priorities will vary through time; during the credit crisis I'm sure counterparty risk became the number one priority for many firms.
Although a major concern of all asset managers, reputational risk does not warrant a separate category; a risk failure in any category can cause significant damage to a firm's reputation.
Compliance or regulatory risk is the risk of breaching a regulatory, client or internally imposed guideline, restriction or clear limit. I draw no distinction between internal or external limits; the breach of an internal limit indicates a control failure, which could just as easily have been a regulatory, or client mandated limit. Of course, the financial impact of breaching limits can be significant; in August 1996 Peter Young of Morgan Grenfell Asset Management allegedly cost Deutsche Bank £300 to £400 million in compensation payments to investors in highly regulated authorised unit trusts. Peter Young used Luxembourg listed shell companies to circumvent limits on unlisted and risky holdings.
Operational risk, often defined as a residual catch-all category to include risks not defined elsewhere, actually includes the risk of human error, fraud, system failure, poor controls, management failure and failed trades. Risks of this type are more common but usually less severe. Nevertheless, it is important to continuously monitor errors and near misses of all types, even those that do not result in financial loss. An increase in the frequency of errors regardless of size or sign may indicate a more serious problem that requires further investigation and corrective action. Although typically small in size, operational errors can lead to large losses. In December 2005 a trader at the Japanese brokerage firm Mizuho Securities made a typing error and tried to sell 610,000 shares at 1 yen apiece in recruiting company J-Com Co., which was debuting on the exchange, instead of an intended sale of one share at ¥610,000 – an example of fat-finger syndrome. Mizuho lost approximately ¥41 billion. In April 2007,3 a programmer at AXA Rosenberg incorrectly programmed a statistical model, leading to $217 million in losses for clients. A Securities and Exchange Commission (SEC) investigation found that senior management learned in June 2009 of a material error, but instead of disclosing and fixing the error a senior official directed others to keep quiet. The error was kept from senior management until November 2009 and from clients until April 2010. According to the SEC, the firm failed to disclose the error and its impact on client performance, attributed the model's underperformance to market volatility and misrepresented the model's ability to control risk. AXA Rosenberg paid an additional $25 million penalty fine.
Liquidity risk is the risk that assets cannot be traded quickly enough in a market to change asset and risk allocations, realise profits or prevent losses. Perhaps liquidity risk has received less attention than it should in the past but it is capable of causing significant damage. The demise of Long Term Capital Management (LCTM)4 in 1998 was really a liquidity issue compounded by massive leverage. In less than one year LTCM lost $4.4 billion of its $4.7 billion capital. LTCM was a hedge fund based in Greenwich, Connecticut that used absolute return strategies combined with high leverage. LTCM had been making losses throughout the summer of 1998 which were further compounded by the Russian Debt Crisis in August and September causing a flight to quality. This resulted in the bidding up of the price of the most liquid securities in which LTCM was short and depressing the price of less liquid securities of which LTCM was long. As rumours of LTCM's positions spread, market participants positioned themselves for forced liquidation; eventually LTCM was forced to liquidate at exactly the wrong time, increasing its losses.
A more recent, and extremely relevant, example in the context of today's markets is the liquidity crisis at the LF Woodford Equity Income Fund (WEIF).5 WEIF, an open-ended investment fund, was forced to suspend dealing in June 2019, to avoid a fire sale of unlisted assets, triggered by the attempted withdrawal of £250 million, or 4%, of the fund's assets by Kent County Council. In the preceding weeks, following a period of poor performance, investors had already withdrawn in excess of £500 million, increasing the already high percentage of unlisted, illiquid assets. The fund had previously circumvented a 10% limit on illiquid assets by bundling up the fund's unlisted assets and listing them on the Guernsey-headquartered International Stock Exchange which had barely any trading activity and was unable to provide sufficient liquidity.6 Extraordinarily, the Governor of the Bank of England said “These funds are built on a lie which is that you can have daily liquidity for assets that are fundamentally not liquid”.7 WEIF might also be described as a compliance risk failure – for a better comprehension of regulatory arbitrage, pushing the envelope and overpowerful portfolio managers, Owen Walker's Built on a Lie8 is a remarkably good read. Understanding liquidity risk in both normal and turbulent markets is a crucial element of effective risk control; the relatively recently identified phenomenon of crowded exits is a characteristic of those turbulent markets.
Counterparty risk occurs when counterparties are unwilling or unable to fulfil their contractual obligations, at its most basic through corporate failure. Counterparty exposure could include profits on an OTC derivatives contract, unsettled transactions, cash management, administrators, custodians, prime brokers and – even with the comfort of appropriate collateral – the failure to return stock that has been used for stock lending. Perhaps the most obvious example of counterparty risk is the failure of Lehman Brothers9 in September 2008.
In the middle office of asset management firms, we are most concerned with portfolio risk, which I define as the uncertainty of meeting asset owner10 expectations. Is the portfolio of assets managed in line with the asset owner's investment objectives? The consequences of not meeting asset owner expectations can be quite severe. Early in 2001,11 the Unilever Superannuation Fund sued Merrill Lynch for damages of £130 million claiming negligence in that Merrill Lynch had not sufficiently considered the risk of underperformance. Ultimately the case was settled out of court for an undisclosed sum, believed to be £70 million, the perception to many being that Unilever won.
Credit risk (or issuer risk) as opposed to counterparty risk is a type of portfolio risk. Credit risk or default risk is the investor's risk of a borrower failing to meet their financial commitments in full. The higher the risk of default the higher the rate of interest investors will demand to lend their capital. Therefore, the reward or returns in terms of higher yields must offset the increased risk of default. Similarly, market, currency and interest rate risks taken by asset managers in the pursuit of asset owner objectives would constitute portfolio risks in this context.
I'm sure readers can quickly add to this brief list of risks and extend through various subdivisions, but I'm fairly certain any risk I've not mentioned so far can be allocated to one or more of the above categories.
RISK MANAGEMENT VERSUS RISK CONTROL
It is useful to distinguish between the ways portfolio managers12 and risk professionals see risk. For this purpose, let us refer to portfolio managers as “risk managers” and to risk professionals as “risk controllers”. Then there is a clear distinction between risk management and risk control. As risk managers, portfolio managers are paid to take risk, they need to take risk in order to achieve higher returns. For the risk manager “Risk is good”.
Risk