Risk Management Issues in European Equity Funds Andrew Clare1, Miguel Corte-Real2, Natasa Todorovic3

Abstract This paper provides a comprehensive analysis of current risk management practices of active European equity long-only funds and hedge funds. Using a unique questionnaire survey we reveal many issues for the industry ranging from insufficient financial commitment of funds to risk management and risk managers not being independent enough and assuming additional roles to the fact that important types of risks (such as style or size risk) are not accounted for and portfolio holdings are infrequently assessed. However, efforts have been made by funds to allocate more resources to risk management since the start of the recent financial crisis. Further, we find that hedge funds tend to be more risk aware than long only institutions and that spending more on risk management is more likely to improve funds‟ performance rankings.

1

Professor in Asset Management, Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, UK, email: [email protected] 2 PhD Candidate, Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, UK, email: [email protected] 3 Corresponding author. Senior Lecturer in Investment Management, Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, UK, email: [email protected]

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1. Introduction Rebonato (2007) describes risk management as the discipline that involves assessing the probability of and, most importantly, reacting to and planning for uncertain events. The last two crises in financial markets, the dotcom bubble burst (2000-2003) and the more recent financial crisis (2008-2009), have made it obvious that no robust contingency plans were in place by many financial institutions. This made the industry and investors rethink many of the paradigms and beliefs fundamental to the crises.

Specifically, the 2008-2009 financial crisis highlighted the lack of effective risk management in the asset management industry, with 1471 hedge funds being liquidated in 2008 and 1023 in 20094, and with asset managers experiencing negative asset growth of €1.4 trillion in 2008. Furthermore, there was a lack of transparency and feasibility in the quantitative tools used to compute the value and risk management for the exotic credit derivatives products. Clearly, risk management was not well understood or used properly by financial companies that operated in this turbulent environment. Bender and Nielson (2009) state that being prepared for unlikely events is the most important lesson learnt from financial crises and advocate proactive risk management of both market and non-market type risks.

This study aims to present an overview of the extent risk management is used in European fund management industry post financial crisis, both in the active long-only equity funds and equity hedge funds. It assesses the level of commitment that funds have made to manage the risk and establishes whether improvements can be made before further financial crises take place. Using a unique questionnaire survey, we determine which risk management systems, structure and tools are currently in use and how they have changed following the start of 2008 financial crisis. Further, the study evaluates whether the funds with smaller assets under management (AUM) spend less on risk management. Finally, we ascertain the link between the amount spent on risk management and the performance of the fund. To the best of our

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HFR Global hedge fund industry Report, First Quarter 2010 (www.hedgefundresearch.com)

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knowledge, this is the first comprehensive study of current risk management practices within active European equity funds.

Our findings reveal that risk management in European active equity funds has a number of flaws, which are particularly prominent among long-only funds. The flaws range from over 70% of the funds using identical risk management system and not accounting for some relevant types of risks (such as size or style risk), to risk managers assuming additional roles and not being independent enough, infrequent revision of a portfolio‟s top/bottom holdings, insufficient allocation of resources to risk management relative to company size etc. The survey also highlights the tendency of smaller funds to spend less on risk management functions. Further, we show that the relation between performance ranking and amount spent on risk management is negative (more spent on risk management indicates better (lower) performance rank), albeit insignificant. Following the start of the financial crisis, the funds are currently more aware of these problems and they are placing more emphasis on risk management by increasing allocation of funds to risk functions. Further research may confirm whether indeed this will prove beneficial and whether the trend is likely to continue in the future.

The paper is organised as follows: Section 2 provides review of relevant literature, Section 3 outlines the methodology, in Section 4 we demonstrate our main findings and Section 5 concludes the paper.

2. Review of Literature 2.1.

The importance of risk management

According to Martellini (2010) the raison d’etre of the investment industry is not to generate alpha or design complex structured products, but to serve investors‟ needs by helping them find solutions to their problems, i.e. provide diversification through asset allocation, and hedging and insurance through adequate risk management. Bender and Nielsen (2009) argue that a successful investment process requires a risk management structure that addresses multiple sources of risk, for instance market risk, sector risk, credit risk and interest rate risk amongst others, which calls for portfolio risk decomposition analysis. The authors lay out a „best risk management practice‟ framework, that rests on 3 pillars: risk measurement (using the right tools accurately 3

to quantify risk from various perspectives), risk monitoring (tracking the output from the tools and flagging anomalies on a regular and timely basis) and risk-adjusted investment management (uses the information from measurement and monitoring to align the portfolio with expectations and risk tolerance). Therefore, portfolio management that relies on successful application of risk management tools and monitoring is of essence for investors. This study aims to assess whether asset management firms in the aftermath of the initial financial crisis period act in accordance with the three principals outlined by Bender and Nielson (2009).

Within asset management industry, the importance of managing risk becomes even more evident since equity portfolio returns are maximized by using different hedging strategies. The review of the literature on hedging can be found in Judge (2006), who emphasizes that the rapid growth in the studies on hedging over the last decade is motivated firstly by the development of a theoretical framework and secondly by the availability of public data. Recent developments in accounting standards regulation have resulted in an increase in the quantity of risk management data and an improvement in the quality of data disclosed in financial statements. These developments have acted as a catalyst and facilitated the recent growth in empirical studies (e.g. Goto and Xu 2010). The empirical examination of hedging theories has been hindered by the general unavailability of data on hedging activities. Until recently, information on a firm‟s exact position in hedging and its methods of hedging (for example, use of derivatives) was closely guarded because it was deemed to be of strategic importance to that firm. It is only recently that firms have been encouraged to disclose information on their hedging policies and their methods of hedging in their annual reports. In the absence of this information, most of the earlier empirical studies used survey data to examine the determinants of corporate hedging (Nance, Smith and Smithson, 1993 and Dolde, 1995). As disclosure of hedging practices in financial reports improved several studies began to search reports for qualitative disclosures (see for instance Francis and Stephan,1993, Wysocki, 1996, Mian, 1996).

Large number of investors incorrectly assumes that that the purpose of risk management is to minimize risk, and that this may erode their potential returns (Litterman, 2003). In fact, equity portfolio risk is a necessary driver of returns and investors/portfolio managers with strong risk management controls ought to feel 4

comfortable targeting and maintaining a higher overall level of risk, thus leading to higher, rather than lower, returns over time. According to Litterman (2003), portfolio managers need to address three main considerations within their risk components: 1) country/sector/large, mid, small capitalization/high, low beta 2) risk objectives and 3) the long-run rate of return of the portfolio. These components are critical in defining portfolio‟s risk profile. Furthermore, the author recognizes the relevance of both the implementation and monitoring of portfolio asset allocations relative to that of the benchmark, as nowadays most of the equity mix within an equity portfolio is conditioned to the benchmark. Since this research focuses on risk management within active equity portfolios, we aim to investigate to which extent the active risk (implied by overweighting equity positions relative to the benchmark) is monitored.

2.2.

Problems within risk management

Brandolini et al (2000) identify three key reasons why asset managers have insufficient risk management practices: 1) Institutional investors manage third party funds so eventual liabilities are those of other people; 2) Losses, therefore, have no immediate impact on the balance sheet of an institutional investor and 3) Most fund managers are concerned with returns relative to a benchmark instead of absolute returns so their portfolio risk analysis often ignores broad market downturns, like those witnessed in 2008.

There is evidence that companies with strong risk management culture suffered relatively less during the 2008-2009 crisis period. Eppler and Aeschmann (2009) identify Goldman Sachs as one such example. Further, Buehler et al (2008) document that the regular communication through daily risk reports and weekly meetings of the firm-wide risk committee enabled Goldman Sachs to withstand the crisis relatively better than their competitors. This puts emphasis on importance of risk management communication particularly during turbulent periods in financial markets.

Darnell (2009) argues that during low probability high-tail risk events such as the recent financial crisis, long volatility positions would have been highly successful. By having limited protection against loss in many portfolios, investors were net short volatility. Since most investors look for strategies that have recently provided positive, consistent, risk-adjusted returns, these short volatility biases looked very 5

attractive to investors, as they had experienced positive performance over the prior 20 years.

However, it was this growing short volatility bias that created so many

problems in the recent downturn.

Risk models by their nature make some simplifying assumptions. In the event of a large percentage of companies relying on the same risk model and treating it as a black box (accepting risk estimates they generate without any questioning), we may observe buying or selling clusters in the market. Therefore, a real problem is inherent in the fact that companies may not use further research but take the results of risk management model as granted. However, according to Brown (2008), there is a danger of investing in risk management departments who build complex models without achieving the desired results, because too much emphasis is placed on the findings of the model. Darnell (2009) asserts that risk models are helpful in judging risk exposures under typical situations, but no substitute for investment judgement exists when it comes to anticipating how portfolios will respond to tail events. Danielsson et al (2006) remind us that financial returns tend to exhibit fat tails, which makes preparation for those tail events even more pressing.

Risk models are

generally based on a normal distribution but if the distribution is platykurtic, then these tail events are more likely to happen. Darnell (2009), however, concludes that it was not the risk models that failed, but rather the inability to solve the limitations of risk models and investment judgement based on an incomplete assessment of risk. This brings us to the fact that perhaps too much focus has been put on the quantitative side of risk management and the new generation of complex risk models (Blommestein, 2010), without considering the qualitative issues.

Another significant problem in the area of asset and risk management is identified by Brown (2008), who finds that one in five fund managers who invested in complex financial instruments admitted to having no in-house specialists with relevant experience. Further, institutional investors who invest in derivatives, collateralized debt obligations (CDOs) or structured products seem to be at a greater risk; with one in three saying they have no in-house experience regarding these investments. This implies that managing the risk of such products is not serviced either.

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Finally a problem may occur if risk managers role is shared and/or if they are not independent enough. Golub and Crum (2010) observe that risk managers can only be truly effective when they are independent from the risk takers, even if those risk takers are highly risk aware. Further, they recommend that the risk management function must be at least of equal standing to the investment function. The head of the risk management department should report directly to the CEO of the company, and not to the CIO.

2.3.

Risk Management Surveys

Surveys are not ordinarily used method in financial risk management literature. To the best of our knowledge, there are no academic papers that survey risk management practices in financial institutions. Nevertheless, Price Waterhouse Coopers completed a survey on valuation and risk management of 68 US, European, Asian and Canadian hedge funds5. They find that for majority of funds some areas of risk management are not sufficiently considered such as counterparty risk and approval of new instruments. They document that hedge funds have diverse view of who should bare prime responsibility for risk management in the company (General Partner, Board of Directors, Senior Portfolio Manager, Independent Risk Manager, CFO etc.). Further, almost 70% of surveyed funds do not have a risk management committee and only 31% have an independent risk manager. Additionally, substantial proportion of respondents (33%) believes that tools used for risk management in hedge funds are not that strong, while 11% considers that risk management process is relatively weak. Finally, it was revealed that performance of only 50% of portfolio managers is made on a risk-adjusted basis, taking into account adequate risk measures. Ernst and Young‟s Risk Management for Asset Management Survey (2011)6 is based on interviewing a very small sample of around 30 UK and European large, medium, small (by assets under management) and alternative asset management firms. They find that, in general, risk management practices in 2011 are improving relative to previous years. Some other interesting findings reported suggest that managing liquidity risk is priority for most of the firms, that investment risk (deviation from an expected return, i.e. volatility) is well managed, that 65% of respondents used Value 5

http://www.pwc.com/en_GX/gx/financialservices/pdf/globalhedgefundsurvey.pdf http://www.ey.com/Publication/vwLUAssets/Risk_management_for_AM_2011Survey/$FILE/Risk_m anagement_for_AM_2011Survey.pdf 6

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at Risk (VaR) to model market risk and that 45% of respondents have increased the size of their risk management team. Further, the survey also assesses respondents view on counterparty risk, operational risk and various aspects of regulation.

To conclude, it is evident from both academic and practitioner point of view that risk management is a very important activity for a financial institution and many of its flaws became obvious during the financial crisis of 2008-2009. Although practitioners‟ surveys have addressed some of the issues that asset management industry is facing in terms of risk management, such as adjustments to the new regulation or allocating additional resources to risk management, improvement of communication etc., the existing surveys, we believe, are not comprehensive enough. They do not attempt to show which specific aspects of financial risk management need improvement, or whether the amount spent on risk management improves funds‟ performance. Also, the surveys are applied on the small sample of respondents, which cannot be deemed representative of the asset management industry as a whole. 3. Data and Methodology 3.1.

Data

This survey focuses on the initial sample of 840 European equity funds, which includes traditional open-ended equity mutual funds and hedge funds. A total of 743 equity mutual funds and their assets under management (AUM) are obtained from FundFile database from Lipper Fund Management Information (Lipper FMI). A universe of 97 hedge funds is from Morningstar Direct7database.

Figure 1 illustrates the criteria applied to form the sample of 840 funds. In the case of traditional open-ended mutual funds8, the ten largest European domiciles by equity assets under management were taken, namely: Luxembourg, United Kingdom, France, Ireland, Sweden, Germany, Switzerland, Netherlands, Italy and Norway. This screening process enables us to get a suitable coverage of the largest equity funds in Europe incorporating both funds in “offshore centres” as well as those funds 7

Morningstar has been expanding their hedge fund coverage by acquiring businesses and databases, such as InvestorForce, which includes the Altvest™ hedge fund database that allows screening of one of the largest proprietary global hedge fund databases available. Hence, these credentials and coverage of the hedge fund universe makes this source suitable for this study. 8 Closed-end funds are excluded.

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domiciled in each local market, accounting for 93% of total assets domiciled in Europe. Figure 1: Screening process for funds

Bond funds, fund of funds (both fettered/unfettered), mixed asset funds, money market, money market enhanced and property funds9 are excluded, as well as equity funds following a passive policy (exchange traded funds and index trackers), leaving only active equity funds in the sample. Note that the sample does include some funds that are classified as pure long-only, but pursue full UCITS III powers and hence have the ability to use derivatives to create synthetic shorts or write covered call options to enhance income. There has been no further filtering based on where underlying stocks are listed and hence the sample includes funds investing in regions throughout the world (UK, Europe, US, Asia, Japan, Emerging Markets, sector specific funds etc). In the final step, for funds that have asset management subsidiaries all the data is aggregated under the overall banner of the head company. This prevents counting separate asset management entities of the same head company multiple times in the final sample. 9

Property funds that invest in shares of real estate companies are included in the sample, while funds that invest in physical property are excluded.

9

To filter the sample of hedge funds from the Morningstar Direct database, we select hedge funds with headquarters in London, focusing only on funds that apply equity based hedge fund strategies. Specifically, the following Morningstar Categories have been used: Hedge Fund Developed Asia Equity, Hedge Fund Emerging Market Equity, Hedge Fund Equity Arbitrage, Hedge Fund Equity Europe, Hedge Fund Global Equity and Hedge Fund US Equity. As for mutual funds, the data per fund is aggregated and used on the company level.

The AUM of this 840 funds sample totals $1.97 trillion with the largest five European equity managers being Fidelity, Blackrock, JP Morgan, Deutsche Bank Group and BNP Paribas10. The top 10 groups account for 30% of total assets, indicating that European equity asset management industry is unconcentrated.

3.2.

Methodology

The methodology in this paper is based on the survey questionnaire designed specifically for the purpose of this research. The questionnaire is composed of 24 questions, 13 of which are split into sub-sections, as shown in Appendix, leading to 56 expected response items per questionnaire. The questionnaire was designed to provide an insight into the importance of risk management within the asset management industry in Europe and identify possible areas of improvement. With that in mind, the two main areas that are the focus of our scrutiny are 1) risk measurement and 2) risk monitoring.

The survey was carried out by one-on-one interviews in the period from January to September 2010. Interviewing was selected in an attempt to achieve a higher response rate than a mail-out would achieve. For instance, Levich, Hayt and Ripston (1999) received a 17.5% response rate from their 1708 surveys mailed during their study of derivatives and risk management practices by US institutional investors. In this survey, we have interviewed 200 respondents, representing 23% of our overall universe of 840 funds. Our respondents include 182 long-only funds and 18 hedge 10

The assets of BNP Paribas include the recently acquired assets of Fortis. This re-emphasises the importance of aggregating assets to the company level to avoid counting subsidiaries of groups as separate entities.

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funds, accounting for 91% and 9% of the sample respectively. 93% of the 200 respondents are Portfolio Managers, while the remaining 7% are Risk Officers, Marketing Heads, Sales, and others within the asset management firm.

In terms of geographic breakdown, UK-domiciled assets represented 61% of the AUM of all respondents, followed by France and Ireland with 9% each, Sweden and Germany with 6% each, Switzerland with 3%, and Netherlands, Italy and Norway with 2% each. The total AUM of the sample of 840 European equity funds is $1.97 trillion, while the total AUM of our 200 respondents is $1.55 trillion, indicating that our respondent funds can be treated as representative of the equity fund management industry in Europe. The average AUM of funds among our respondents is $9.023bn.

4. Findings 4.1.

The Use of Risk Management Systems

Different risk systems provide diverse tools for effective risk management and they differ in terms of assumptions and underlying risk models they use. We identify 15 risk systems (models) that funds in our sample use. Table 1 presents the proportion of funds that employ each of those risk management systems. Note that those proportions do not add up to 100% as 14.84% of long only funds and 33% of hedge funds use more than one risk management system. It is evident from Table 1 that a large majority of those 200 funds surveyed (76.5%) use Barra‟s Risk Management system. In-house risk management tools are a distant second, employed by 19% of respondents. The same pattern is observed for both long-only funds and hedge funds in our sample:

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Table 1: The use of Risk Management Tools among Surveyed Funds Risk Management Tool

Long only Funds

Hedge Funds

All Funds

Barra

79.12%

50.00%

76.50%

Algorithmics

1.65%

-

1.50%

APT

0.55%

-

0.50%

Barrie and Hibbert

0.55%

-

0.50%

Financial Analytics

1.10%

-

1.00%

In-house System

18.68%

22.22%

19.00%

Sophis

4.40%

16.67%

5.50%

Morgan Stanley Risk Mgt

1.65%

22.22%

3.50%

Goldman Sachs Risk Mgt

-

16.67%

1.50%

Riskmetrics

3.85%

5.56%

4.00%

Statpro

1.65%

-

1.50%

EM applications

0.55%

-

0.50%

-

5.56%

0.50%

0.55%

-

0.50%

-

5.56%

0.50%

0.55%

-

0.50%

Murex Sungard Deutsche Bank Risk Mgt None

Note: - indicates that the corresponding system was not used by any of the funds in the group. Percentages represent the proportion of funds that has used the system. The sum of percentages in any of the columns does not add to 100% as 14.84% of long-only funds and 33% of the hedge funds use more than one risk management system.

The fact that majority of funds use the same risk management tool may prove problematic and can in fact cause contagion, particularly in the downmarket. For instance, when the market is more volatile, portfolio managers have more pressure to scale their positions and measure risks (DeMiguel, 2010). It is precisely their risk system that measures what positions are riskier and which ones should be sold to reduce the portfolio risk. If the great majority of portfolio managers use the same tool to measure risk, that may create a selling cluster. The evidence of the worst returns clustering can be found in Boyson, Stahel and Stalz (2008) who use monthly hedge fund indices representing eight different styles from January 1990 to August 2007.

Although majority of the companies use the same system, given different risk profile of long-only funds and hedge funds, the frequency at which they consult those systems differs, as illustrated in Figures 2a and 2b. 12

Figure 2: Frequency of usage of Risk Management Systems 2a. Long-only Funds

1%

2b. Hedge Funds

15%

17%

25%

18%

17% 66%

41% Daily

Weekly

Monthly

Quarterly

Other

Daily

Weekly

Monthly

Quarterly

The majority (74%) of long-only portfolio managers apply their risk tools at least once a month with only 15% resorting to this daily. A different image emerges for hedge funds: two thirds (67%) of hedge fund managers check their risk systems on a daily basis, while none of those surveyed use the systems less frequently than once a month. Given that hedge funds traditionally deploy high-risk strategies, it is reassuring to find that hedge fund managers are more concerned about understanding their portfolio risk on a more frequent basis than long-only managers. Additionally, in periods of high volatity, such as the period of subprime crisis that started in 2007, it is necessary to review risk more frequently in order to make adeqaute portfolio adjustments and avoid losses. Further, this survey investigates the extent to which fund managers use Style Research Ltd tool in addition to more general risk management system, as it provides a comprehensive analysis of market risk and style factors in portfolios. This is of particular relevance for long-only equity portfolios as many of them follow value, growth, small capitalization or large capitalization portfolio construction approach. Equity style investing is recognized as a profitable investment strategy by both academics and practitioners, evidence of which can be found in influential papers such as Banz (1981) and Fama and French (1993). Given that Style Research Ltd. tool enables portfolio managers to track different risk behavior, the possible change in risk premium and any style bias in their portfolios, it is of less relevance for hedge funds who are less concerned about style bias than other types of risks in their portfolio. Therefore, it is not surprising that only 22% of hedge fund managers resort to it (Figure 3b). On the other hand, this tool could prove to be 13

Other

invaluable for long only funds pursuing strategies with size or style bias, yet only 57% of surveyed funds employ it (Figure 3a), 73% of which do so only once per quarter or once in six months (Figure 3c). Those hedge fund managers that are concerned with style bias may be proportionally small in numbers, but they appear to be more diligent, as 75% of them monitor it at least once per month, with 25% of funds applying daily style analysis (Figure 3d). Figure 3: Style Research Ltd tool and its use 3a. Proportion of Long-only funds

3b. Proportion of Hedge funds

that use Style Research Ltd.

that use Style Research Ltd.

Yes Yes

No

No

22%

43%

57%

78%

3c. Frequency of use: Long-only funds

Daily

Weekly

Monthly

3%

Quarterly

3d. Frequency of use: Hedge funds

Daily

Semi-annually

Weekly

Monthly

Quarterly

8% 25%

25%

25%

25%

19%

70%

4.2.

Risk Management Resources, Structure and Communication

4.2.1. Resources To determine the risk management resources in surveyed funds we firstly look at the number of individuals that are part of the risk management teams. Figures 4a 14

and 4b reveal that only 36% of long-only funds and 28% of hedge funds has more than 10 people in the risk management team. Figure 4: The size of risk management teams 4a. Long-only Funds

1-5

4b. Hedge Funds

1-5

6 - 10 10+

6 - 10 10+

28% 36%

40%

6% 66%

24%

In both groups of funds the most common risk management team size is 1-5 people, which is rather low given that the average AUM of all the funds is the sample is $9.023bn. To examine this issue further, we present Table 2 that shows the average AUM of our respondent firms that have small risk management teams (1-5 people), medium risk management teams (5-10 people) and large risk management teams (more than 10 people). Table 2: The average AUM across different sizes of risk management teams Size of the risk management team Small (1-5 people) Average AUM (in $bn)

Medium (6-10 people)

6.151

5.818

Large (over 10 people) 14.582

One would expect that the relationship between the size of the risk management team and the average AUM is positive so that the companies that on the average have the lowest AUM will also have the smallest risk management teams, and vice versa. While this positive relationship holds for the large risk management teams, the companies that have the fewest people managing risk are not the smallest in terms of AUM, which in turn indicates that companies do not allocate resources to risk management in proportion to the size of their assets. 15

Further, in order to understand the strength and dedication of the risk department in general and risk management officer in particular, it is of importance to determine if risk managers‟ position assumes any additional roles. We find that 88% of long-only firms in the sample have dedicated risk managers, while the corresponding figure for hedge funds is only 56%, as shown in Figures 5a and 5b. It can be said that a considerably large proportion of hedge fund risk managers assumes additional roles and are not devoted sufficiently to their primary role of managing risk. Figure 5: Do Risk Managers Assume Additional Roles? 5a. Long-only Funds

5b. Hedge Funds

Yes Yes No

12% No

44% 56% 88%

In addition, facts revealed in Figures 4b and 5b are somewhat linked: the reason why a risk manager in a hedge fund has to undertake other duties may be linked to a small team size (66% of hedge funds reports risk management teams of up to 5 people). Hedge funds in our sample have considerably smaller AUM compared to long only funds (average of $2.8bn vs. $9.7bn respectively) and therefore fewer resources to fund larger teams in which members will assume only one role. The nature of additional roles they execute may also be of importance as this may lead to a conflict of interest, which will to some extent be addressed in the next section. 4.2.2. Reporting structure The degree of independence of risk management team can be measured by assessing the reporting relationships with the company. If the head of risk management reports to the CEO, there may be some conflicts of interest and lack of objective judgment when it comes to balancing risk management against reaching performance targets. 16

Clearly, the role of the Chief Investment Officer and the Chief Risk Officer should be different in aims and therefore more objective. Figure 6a and 6b show reporting structure in funds in our sample. Figure 6: Reporting structure 6a. Long –only funds

CIO

Investment Risk Oversight Committee

6b. Hedge Funds

CIO

Other

Investment Risk Oversight Committee

Other

0% 4% 22%

44% 56%

74%

Our survey reveals that the risk management process in 74% of of long only institutions is more independent as they report to their Investment Risk Oversight Committee, while 22% still shows lower degree of independence and report direct to their CIO11. Further, hedge funds exhibit lower degree of independence than longonly funds as only 44% of Risk Managers in hedge funds report to their Investment Risk Oversight Committee, while 66% report directly to their CIO. This can also be explained by the fact that hedge funds have lower AUM on the average than longonly funds, and therefore fewer resources to establish and run a risk oversight committee. Furthermore, as part of the reporting structure and decision making in the company, it is important to identify who has the authority to make changes to the portfolio if its risk deviates outside the set risk parameters: Portfolio Manager, Risk Manager, Head of Equity or CIO?

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A minority of 4% of risk managers in the long-only funds in this sample report to other authorities within the company such as Chief Operating Officer or Head of Equities.

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Figure 7: Authority to make changes in a portfolio 7a. Long-only

CIO

Head of Equities

Risk Manager

7b. Hedge Funds

Portfolio Manager

Other

CIO

Head of Equities

Risk Manager

Portfolio Manager

Other

0% 1%

2%

30%

6%

30% 39% 33%

37%

22%

Across the long-only funds, the responses are fairly evenly split between the Head of Equities (30%), the Risk Manager (37%) and the Portfolio Manager (30%), as seen in Figure 7a. For hedge funds (Figure 7b), there is more involvement of the CIO and Portfolio Manager in the final risk decision (6% and 39% respectively) than for long only managers, but the decision making role of the Risk Manager is reduced. The findings that portfolio managers take on risk management responsibilities in large proportions of funds raises the question of whether companies provide enough separation of responsibility of those two roles, especially when the risk characteristics deviate from those stated in the fund‟s mandate. Furthermore, it raises doubts about the portfolio manager‟s ability to independently separate the risk management from the portfolio management functions. However, it should be noted that for hedge funds this could be just a consequence of the smaller size of hedge funds teams and organizations, meaning that shared roles of responsibility are more likely, as seen in section 4.2.1. 4.2.3. Communication Between Portfolio Manager and Risk Manager The communication links in long only funds and hedge funds notably differ: more than half (57%) of fund managers in long only funds meet their risk managers only once per quarter, while almost half of the hedge fund managers (44%) does so on a daily basis (Figure 8a and 8b).

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Fgure 8: Frequency at which fund managers meet risk managers 8a. Long-only Funds

Daily

Weekly

Monthly

1%

2%

8b. Hedge Funds

Quarterly

Other

Daily

Weekly

Monthly

6%

10%

Quarterly

Other

0%

22% 44% 30% 57%

28%

It is of concern that 6% of hedge fund managers meet risk managers only once per quarter, and therefore appear to be less dilligent and insufficiently prepared for handling risk. In contrast, just 2% of long-only managers opts for daily meetings and opportunity to have better overview of risk in their portfolios. These findings are in line with frequency of use of risk management systems discussed in Section 4.1, which imply that hedge fund portfolio managers are more concerned about risk in the short run than long-only managers. 4.3. Frequency of evaluation of funds’ active positions

4.3.1. Assessing the aggressiveness of strategies Typical measures of aggressiveness of funds‟ strategy is its divergence from a benchmark (i.e. the size of the tracking error, a measure used for active management in Wermers (2003)), and the comparison of portfolio vs. benchmark holdings (as for instance an Active Share measure suggested by Cremers and Patajisto (2009) that measures how funds overweight and underweight the portfolio holdings relative to the benchmark). More aggressive strategies imply greater tracking error and greater divergence from portfolio benchmark and in turn higher risk.

Given that our sample contains only active funds, one would expect that they will review their active positions very frequently. Nevertheless, Figure 9a and 9b exemplify that only around one fifth of long only portfolio managers evaluate their

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active positions and tracking error on a very frequent basis. Additionally, nearly 8% of respondents never assess thir active positions.

Figure 9: Evaluation of active positions 9a. Long-only Funds

Ex-Ante Tracking Error (%)

19.6%

49.2%

19.0%

3.9%

8.4%

Underweights vs benchmark

21.4%

47.3%

18.7%

7.7%

4.9%

Overweights vs. benchmark

21.4%

47.8%

18.1%

7.7%

4.9%

0%

10%

20%

very frequently

30%

40%

frequently

50% rarely

60%

70%

never

80%

90%

100%

n/a

9b. Hedge Funds

Ex-Ante Tracking Error (%)

33.3%

11.1%

55.6%

Underweights vs benchmark

22.2%

11.1%

66.7%

Overweights vs. benchmark

22.2%

11.1%

66.7%

0% very frequently

20%

40% frequently

60% rarely

never

80%

100%

n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

Hedge fund managers give binary response with regards to looking at tracking error and active positions: they assess them either very frequently or not at all, with twothirds of hedge funds giving no relevance to assessing active benchmark positions at all. This could be explained by the fact that they are not managed against traditional benchmarks, like the FTSE or MSCI type indices, and are generally judged on an absolute, not a relative returns basis. The same cannot be said for the long-only funds: in spite of the fact they are benchmarked against traditional indices – the long-only respondents do not analyse their active money as frequently as expected.

20

4.3.2 Assessing country and sector risk exposure Given the interconnectedness of the global economy and the recent increase in the volatility of sovereign debt in Europe, it is important for the funds to consider their country exposures with a greater degree of diligence. Further, as Baca, Garbe and Weiss (2000) show that the international sector exposure contributes more to diversification of risk than the country exposure; it adds value to assess if companies review their foreign (and domestic) sector positions on a frequent basis. The results of the survey are in Figure 10a and 10b, showing that hedge funds tend to be less concerned about the country and sector relative weights than long only funds. Figure 10: Assessing country and sector exposures and contribution to risk 10a. Long-only funds country and sector exposure

Country relative weights

14.9%

51.4%

20.4%

Sector weight position vs. previous year

14.4%

51.9%

21.5%

8.3%

3.9%

Country breakdown vs previous quarter

13.9%

52.2%

21.7%

8.3%

3.9%

0%

20%

very frequently

40% frequently

60% rarely

80%

never

5.5%

7.7%

100%

n/a

10b. Hedge funds country and sector exposure 0.0% Country relative weights

27.8%

11.1%

61.1% 0.0%

Sector weight position vs. previous year

38.9%

27.8%

33.3% 0.0%

Country breakdown vs previous quarter

38.9% 0% very frequently

22.2%

20%

38.9%

40% frequently

60% rarely

never

80%

100%

n/a

10c: Long-only Funds: Top10/Bottom 10 countries’ and sectors’ risk contribution as a percentage of tracking error

Countries – Top 10 Risk Contributors as % of Tracking Error

8.3%

Sector Top 10 Bottom 10 Risk Contributors as % of Tracking Error

53.6%

7.8% 0% very frequently

55.6% 20% frequently

21

17.7%

40%

17.2% 60% rarely

7.2%

13.3% 13.3% 80%

never

6.1% 100% n/a

10d: Hedge Funds: Top10/Bottom 10 countries’ and sectors’ risk contribution as a percentage of tracking error

5.6%

Countries – Top 10 Risk Contributors as % of Tracking Error

27.8%

22.2%

44.4% 5.6%

Sector Top 10 Bottom 10 Risk Contributors as % of Tracking Error

27.8% 0% very frequently

27.8%

20% frequently

40%

38.9% 60% rarely

80% never

100% n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

Further, we analyse whether the surveyed funds consider the contribution of Top 10 and Bottom 10 countries (sectors) in their portfolios to the tracking error. Figure 10c shows that most long-only funds review their country and sector contributions to risk on a frequent basis, recording 53.6% and 55.6% of the reponses respectively. However, over 17% of funds rarely takes these risk contributions into account, while over 13% of funds never considers them. Hedge funds (Figure 10d) exhibit „all or nothing‟ behaviour: around 50% of hedge funds assign great importance to Top 10 and Bottom 10 country and sector contributors to tracking error, reviewing them either frequently or very frequently. The remaining 50% do not consider the contribution of country/sector positions to their total tracking error at all, mostly because they consider it not relevant. During the subprime crisis in the late 2000s, country risk assumed a crucial importance. Considering that country and sector positions play an important role in determining the performance and risk profile of the fund, portfolio managers in both long-only and hedge funds and are still yet to consider this new reality as our findings reveal that the risk management in this area is neglected by large proportion of funds. 4.3.3. Security selection contribution to performance and risk It is relevant to analyse the cumulative contribution of the top 10 bets within the portfolio since 1) they often account for a substantial portion of the performance and the risk of the portfolio (Brandt, Santa Clara and Valkanov, 2009); and 2) they play a significant role in determining the portfolio manager‟s total value added. Nevertheless, the survey discloses (Figure 11a) that over 30% of long-only managers either rarely or never considers this, while 63.1% consider this at least frequently. 22

Figure 11: Performance contribution of Top 10 bets 11a. Long-only funds

Cumulative Contribution of top 10

15.6%

0%

47.5%

20%

very frequently

24.0%

40% frequently

60% rarely

7.8%

80%

never

5.0%

100%

n/a

11b. Hedge Funds

Cumulative Contribution of top 10

66.7%

0% very frequently

20%

33.3%

40% Frequently

60% Rarely

Never

80%

100%

n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

Hedge funds assign much more importance to contribution from top 10 bets than their long-only counterparts, as seen in Figure 11b, with two-thirds of hedge fund managers considering this on a very frequent basis, while the remaining one third frequently. This may reflect the fact that long only managers (as opposed to hedge funds) tend to place large bets on „long-term winners‟ and are not so concerned with short-term “noise” affecting the performance of their top holdings.

Additionally, it is of relevance for funds to consider which stocks among the largest and the smallest holdings are the main contributors towards performance (both over or underperformance). To reflect this, we assess if the funds in our sample analyse frequently enough quarterly stock contribution from Top 20 and Bottom 20 positions. Further, given that all our funds in the sample follow active investment philosophy, it is important to assess whether they distinguish between stock picking skills and market behaviour (Alpha and Beta). To do that, funds can look at the Active money vs. Beta of the portfolio. Although active money does not directly measure the risk of a portfolio but simply represents the amount of the over/under exposure in a particular 23

stock relative to the benchmark; active money relative to beta measures whether such over/under exposure is linked to high/low betas and in turn shows portfolio managers the degree to which portfolio risk deviates from the benchmark. Our findings exemplify that long-only fund managers do not really regard these factors as important, as shown in Figure 12a. Only 14.9% of long-only portfolio managers look at active money versus beta on a very frequent basis, a large 23.8% rarely assess it, while 7.2% never consider it. A similar pattern is shown towards looking a relative contribution from the top 20 and bottom 20 positions. Figure 12: Quarterly Stock Contribution 12a. Long-only Funds

7.2% 14.9%

Active Money vs. Beta

45.9%

23.8%

8.3% 6.6%

Relative contribution for Top 20, Bottom 20

16.0%

48.6%

0%

20%

very frequently

22.1%

40% frequently

60% rarely

6.6%

80%

never

100%

n/a

12b. Hedge Funds

27.8%

Active Money vs. Beta

Relative contribution for Top 20, Bottom 20

27.8%

44.4%

50.0%

0%

20%

very frequently

38.9%

40% frequently

11.1%

60% rarely

never

80%

100%

n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

Hedge funds show a more binary outcome when reviewing risk factors, with 44.4% (11.1%) not considering active money versus beta (relative contribution from top 20 and bottom 20 stocks), while the rest of the funds are considering it at least frequently, as Figure 12b illustrates.

4.3.4 Size risk It is a stylized fact that stock size matters (Banz 1981, Dimson and Marsh, 1986). From the risk perspective, market capitalization is considered by many academics to be a risk factor itself, as seen in Cahart (1997) four factor model or Fama and French (1993) three factor model. Small size stocks in particular are perceived to carry more risk due to being associated with the lower liquidity and greater trading costs (see for 24

instance Stoll and Whaley, 1983); they have more cashflow problems, higher financial leverage and generally struggle more than the large capitalisation firms particularly during market downturns, as argued by Chan and Chen (1991). Figure 13 portrays to what extent fund managers consider size as a risk factor in their portfolios. Figure 13: Frequency of size contribution analysis 13a. Long-only Funds

6.7% 14.5%

market cap distribution

54.2%

20.7%

3.9% 6.7%

breakdown by market cap

14.4%

0%

54.4%

20%

very frequently

40% frequently

3.9%

20.6%

60% rarely

80%

never

100%

n/a

13b. Hedge Funds

market cap distribution

breakdown by market cap

0% very frequently

38.9%

44.4%

11.1%

5.6%

38.9%

44.4%

11.1%

5.6%

20%

40% frequently

60% rarely

never

80%

100%

n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

Market capitalization distribution in the portfolio and breakdown of holdings by capitalisation emerges as an important parameter on the back of liquidity and other concerns, as over 54% of long-only funds (44% of hedge funds) considering the market cap impact frequently, with another 14.5% (38.9% of hedge funds) considering it very frequently. Still, it is of concern that 20.7% of long-only funds (11.1% of hedge funds) only rarely look at this indicator. Although hedge funds are more concerned about size risk and indirectly liquidity risk, there is unsettling 5.6% of those who do not consider it relevant at all.

4.3.5. Emerging Markets risk Emerging markets have played a central role in equity allocation in recent years, as their risk premia is larger than on developed markets. At the same time, the main tenet of efficient market hypotheses states that greater returns imply greater risk (Samuelson, 1965 and Fama, 1970). Indeed, there is evidence of significant 25

relationship between mean returns and standard deviations in emerging markets (see for instance Harvey, 2000 and Estrada 2000, 2002). The extent to which surveyed funds evaluate the exposure to emerging markets is shown in Figure 14. Figure 14: Frequency of analysis of the emerging markets relative bet to index 14a. Long-only funds

How often do you analyze the Emerging Markets Relative Bet to index?

12.1%

52.6%

0%

20%

very frequently

40% frequently

7.5%

22.5%

60% rarely

never

5.2%

80%

100%

80%

100%

n/a

14b. Hedge Funds

How often do you analyze the Emerging Markets Relative Bet to index?

23.5%

0% very frequently

17.6%

5.9%

20%

40% frequently

52.9%

60% rarely

never

n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

With the importance of emerging markets increasing over the past two decades, and with emerging markets projected to be a major growth driver for future returns in markets, many managers have turned to them to generate returns and provide diversification. Figures 14a and 14b indicate that hedge funds are less concerned about exposure to emerging markets. Only 47.1% of hedge funds assess this exposure, compared to 87.3 of long only funds. However, 50% of those hedge funds that do consider this, apply the analysis on a very frequent basis, which is much higher than their long-only funds equivalent (13.9%). It is worth noting that hedge funds in our sample that do not find monitoring exposure to emerging markets necessary are those that do not have exposure to those markets.

4.4. Assessing liquidity risk of portfolios 4.4.1. Number of days to liquidate the portfolio Liquidity risk, defined by Jorion (2007) as risk arising when a forced liquidation of assets creates unfavourable price movements, is a crucial area of risk management 26

and asset management in particular. It is not possible to accurately value portfolios without taking into account the liquidity of its positions. Many factors can shape the liquidity of a portfolio, such as holding a large position in one stock or holding small position in a stock that is not frequently traded.

Tolga (2004) argues that monitoring portfolio liquidity is of essence in order to run day-to-day business of hedge funds, but his arguments can be applied for any type of fund. Sufficient liquidity would provide an instant access to cash needed for, say, investor withrawals or, in the case of hedge funds, for margin or capital calls from prime brokers. Figure 15a and 15b show that the number of days needed to liquidate the portfolio represents an overriding liquidity indicator financial institutions utilise: 94% of hedge fund managers (78% long-only) are revising this on at least a frequent basis. Other liquidity issues such as change in exposure to sectors over different periods are also reviewed, but less frequently than number of days to liquidate the portfolio for both groups of funds. Figure 15: Assessment of portfolio liquidity 15a. Long-only Funds

5.0% Sector weight position vs. previous quarter

26.5%

43.6%

4.4%

20.4% 5.0%

Sector weight position vs. previous month

27.6%

43.1%

19.9%

4.4% 5.6%

Number of days for the institution to liquidate portfolio

27.2%

44.4%

20.0%

2.8% 3.8%

Number of days to liquidate portfolio

44.5% 0%

very frequently

frequently

33.5%

20%

40%

rarely

never

0.0%

18.1%

60%

80%

100%

n/a

15b. Hedge Funds

5.6% Sector weight position vs. previous quarter

33.3%

Sector weight position vs. previous month

33.3%

Number of days for the institution to liquidate portfolio

5.6% 5.6% 5.6% 55.6%

Number of days to liquidate portfolio

55.6% 5.6% 5.6% 33.3% 5.6% 5.6%

88.9% 0%

very frequently

55.6%

frequently

20% rarely

40% never

60% n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

27

80%

100%

Finally, it can be noted that hedge funds are more concerned about portfolio liquidity than their long-only counterparts.

4.4.2. Analysis of the cash position Cash is an important part of a portfolio. On one hand, it dampens the effect of volatility, facilitates redemptions and generally provides instant liquidity in a portfolio (Simutin, 2010). On the other, the returns on the cash tend to be lower than on equity, and many portfolio managers are encouraged by their investors to put cash to work. Figure 16: How frequently is the cash position analysed? 16a. Long-only funds

Daily

Weekly

Monthly

Quarterly

Semi-annually

16b. Hedge Funds

Daily

Other

Weekly

Monthly

Quarterly

Semi-annually

Other

1% 2%

17%

0%

22% 44%

31%

83%

It is evident from Figure 16 that an overwhelming majority (83%) of hedge funds analyse their cash position every day, and none of those surveyed look at this less frequently than every week. Comparatively, less than half (44%) of long-only funds analyse their cash position daily, but nearly all do look at this at least once a month. This corroborates the findings of section 4.4.1 that hedge funds appear more diligent in assessing liquidity risk then long-only funds. However, this may indicate that hedge funds may be more concerned about client redemptions, margin or capital calls from prime brokers, for which the cash is often used.

4.5. Analysis of risk decomposition Various types of risks can be driving returns of portfolios, such as stock specific (idiosyncratic), country risk (including a) domestic market, i.e. systematic risk, and b) foreign market risk), industry risk and currency risk. Benchmarking portfolio risk against a risk index12 may also be relevant to understand risk decomposition within a

12

Examples of risk indices can be Barra Global Long term Indices based on volatility, momentum, growth, value, liquidity, size, size nonlinearity and financial leverage factors.

28

portfolio. The frequency at which the surveyed funds analyse these risk parameters is shown in Figure 17a and 17b. Figure 17: Frequency of Analysis of Risk Decomposition Parameters 17a. Long-only Funds

Currency Risk

10.7%

31.5%

14.6%

13.5%

29.8%

11.6%

29.3%

16.0%

13.3%

29.8%

Risk Index Industry Risk

12.1%

30.8%

14.8%

13.2%

29.1%

Country Risk

12.6%

30.8%

14.8%

12.6%

29.1%

Stock Specific Risk

11.5%

34.1%

0%

13.2%

20%

very frequently

40% frequently

12.6%

28.6%

60% rarely

80%

never

100%

n/a

17b. Hedge Funds

Currency Risk

33.3%

Risk Index Industry Risk Country Risk Stock Specific Risk

5.6%

27.8%

5.6%

27.8%

5.6%

61.1% 66.7% 66.7%

33.3%

5.6%

61.1%

33.3%

5.6%

61.1%

0% very frequently

20%

40% frequently

60% rarely

never

80%

100%

n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

Given that all funds in our sample are active, it is surprising to see that these core types of risks are not overly considered by either group of funds. While just over 10% of long-only funds analyses these parameters very frequently, around 13% of them never considers them. Therefore, it is evident that long-only funds do not consider the parameters frequently enough, whereas around 70% of hedge funds does not consider them at all. One third of hedge funds that does take into account risk decomposition parameters, reviews them very frequently, applying a more sensible risk management approach. Furthermore, it would be of interest to address the issue of whether fund managers consider how much some types of risks common for equity portfolios are accounted

29

for in the tracking error of their portfolios. The risks we consider are tail risk, growth, financial leverage, liquidity, value, momentum, size and volatility. The importance of these types of risks is well documented in academic literature. For instance, Campbell, Lo and MacKinlay (1997) find evidence of fat tails in stock markets, which are important to detect in order to avoid under or over-estimation of portfolio losses. Extensive research has been done on the risk and performance of value, growth and small size stocks (see for example Fama and French, 1992, 1996), so the contribution of any of those groups of stocks to the risk of portfolio should not be underestimated in any equity portfolio. Momentum has been widely accepted as a risk factor in a portfolio, as documented by Carhart (1997). Further, leverage is of particular importance to hedge funds that extensively use leverage in their strategies to gain increased exposure to desired market segments. While on one hand leverage can help increase in returns and maintenance of the desired portfolio risk, it can undoubtedly boost the liquidity risk and counterparty risk13. Therefore, adequate monitoring of financial leverage is imperative for funds that apply high leverage strategies. Finally, as seen in previous sections, liquidity is normally perceived by investors as a very important risk factor, particularly during times of market downturns, when the underlying equity volatility is higher. Benston and Hagerman (1974), Amihud and Mendelson (1989) and Brunnemeier and Pedersen (2008) find that liquidity decreases at the times of increase in market volatility. At those periods, many fund managers sell less liquid securities in order to replace them with more liquid ones, i.e. exhibit „flight to liquidity‟ behaviour. For instance, Acharya and Pedersen (2005) review in detail the literature on liquidity in asset pricing and document that illiquid stocks have liquidity risks, measured through their liquidity-adjusted CAPM model and find evidence of „flight to liquidity‟. Therefore, given that our survey is conducted in 2010, amid the recent financial crisis, assessing whether funds consider liquidity and volatility as part of the tracking error is imperative. Figure 18a and 18b show to which extent surveyed funds account for these risks.

13

http://www.edhec-risk.com/latest_news/featured_analysis/RISKArticle.2008-1010.2612?newsletter=yes

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Figure 18: Frequency of analysis of contribution of various risks to the tracking error 18a. Long-only Funds

Tail Growth Financial Liquidity Value Momentum Size Volatility

12.4% 4.5%

1.7%4.0%

6.2%

7.9%

2.8% 7.3%

6.2%

75.7%

6.7%

79.8%

3.4%

7.3%

74.0% 64.1%

3.6% 3.6% 4.0% 3.9%

6.0%

4.5%

5.1%

5.6%

2.8% 3.3%

7.8%

3.4%

6.8%

24.9%

79.7%

6.7%

80.3%

37.8%

0%

5.0%

79.0%

7.8%

20%

3.3%

5.6%

40%

very frequently

45.6%

60%

frequently

rarely

80%

never

100%

n/a

18b. Hedge Funds

Tail Growth Financial Liquidity Value Momentum Size Volatility

35.3%

0.0%

29.4%

64.7%

11.8%

37.5%

0.0%

58.8%

6.3% 0.0%

56.3%

88.9% 25.0%

0.0%

0.0%

23.5%

0.0%

29.4%

76.5% 0.0%

70.6% 77.8%

0%

20% very frequently

11.1%

75.0%

0.0%

40% frequently

60% rarely

never

80%

22.2%

100%

n/a

Note: n/a refers to „not applied‟ / „not relevant‟ for the fund

It can be seen that liquidity, followed by volatility, are considered the most by long only funds, which is intuitively right as the study covers the period of bear market. It is interesting to note that for instance style risks, such as growth, value, size or momentum are largely ignored, although many funds in our long-only sample follow investment strategies based on style analysis.

31

Comparatively, all types of risks are given greater consideration by hedge funds than long-only funds.

For example, a massive 88.9% of hedge fund managers very

frequently review the contribution of liquidity to their tracking error, while 77.8% very frequently review volatility. It is surprising though that financial leverage is not reviewed at all by over 60% of the funds, given that hedge funds are well known for excessive financial leveraging. 4.6. Analysis of Portfolio Turnover and Performance 4.6.1. Frequency of Analysis of Portfolio Turnover Portfolio turnover is important to assess how trading costs and frequent changes in a portfolio have an effect on performance. For instance, Carhart (1997), among others, finds that there is a negative relationship between turnover and performance, documenting that an increase in turnover by 1% will lead to reduction of the annual abnormal return of a mutual fund by 0.95%. The importance of turnover for cost and risk management overall is even more magnified for hedge funds as many of them apply highly aggressive strategies with very high daily turnover rates, as suggested by Madhavan (2002). Therefore, fund managers who apply analysis of a fund‟s turnover at a high frequency might help to improve portfolio performance as they would gain a better understanding and control of their costs. Figure 19 illustrates our findings. Figure 19: Frequency of Portfolio Turnover Analysis 19a: Long-only funds

19b: Hedge funds

1% 6%

6% 0% 20%

30%

22%

50%

22% 43% Daily

Weekly

Monthly

Quarterly

Semi-annually

Daily

32

Weekly

Monthly

Quarterly

Semi-annually

Out of 182 long-only and 18 hedge funds, only 6% of long-only review portfolio turnover daily, compared to 50% of hedge funds, thus making the daily turnover assesment the most popular method for hedge funds. For long-only funds, the most common frequency at which portfolio turnover is analysed is monthly (for 43% of the funds in the sample). Furthermore, 2% of long-only funds consider turnover only twice per annum. This finding leads us to conclude that long-only funds are not as aware of the effects of the cost of portfolio rebalancing on their performance as hedge funds. 4.6.2. Peer-group Perfomance Assessment Peer-group benchmarking is of particular relevance for active managers as this is how their success (or failure) is judged, both externally by clients and internally for remuneration. Figure 20: Frequancy of Peer-group Performance Assessment 20a: Long-only funds

20b: Hedge Funds

15%

32%

63% 83%

Monthly

Quarterly

Semi-annually

Monthly

Quarterly

Semi-annually

Figure 20 signals that a large 83% of long-only managers review their performance versus peers on a quarterly basis, while 63% of hedge funds apply peer-group analysis every month. This difference in frequency of comparing performance to peers may be the result of more dynamic strategies applied by hedge funds and their tendency to exhibit a shorter-term investment horizon than long-only funds. Nevertheless, analysing performance vs. peers for active portfolio managers should be crucial to help assess return and risk taken relative to the competitors in the field.

33

4.7. The Impact of 2008-2009 Financial Crisis on Investment in Risk Management It is interesting to examine whether there has been a change in spending on risk management following the 2008 Lehman Brothers collapse, after which risk management practices of financial institutions were widely criticized. Figure 21 shows the amount long-only funds and hedge funds spent on risk management per annum in 2010. Figure 21: The Amount Spent on Risk Management in 2010 (p.a) 21a: Long-only funds

Below $5mn

Between $10 to $20mn

21b: Hedge funds

Below $5mn

Above $20mn

Between $10 to $20mn

Above $20mn

11%

21%

44%

28% 61%

35%

Figures 21a and 21b reveal the lack of financial commitment of senior management towards risk management for both long-only and hedge funds. Specifically, 44% of long-only equity funds spend less than $5million on risk management annually; 35% spend between $10million and $20million and just one fifth (21%) of long-only funds spend more than $20million. Similarly, a considerable number of hedge funds (61%) spend less than $5million on risk management annually, while 28% spend between $10million and $20million. Only 11% spend more than $20million. One may argue that amount spent on risk management is linked with the size of the company. The total assets within the respondents sample aggregate to approximately $1.55 trillion, but the amount spent on risk management as a percent of assets managed still seems to be very limited. Hedge funds spend less on risk management than long only firms in absolute terms, but on the average they have lower AUM, as noted in section 4.2.1. At the same time, in spite of spending on risk management

34

being low, it rises with the size of AUM of the long-only funds. The same cannot be inferred for hedge funds, as Table 3 documents. Table 3: Amount spent on risk management (p.a) relative to average AUM of the funds Average AUM per type of fund

Amount Spent on risk Management p.a. Below $5 million

$10 - $20 million

5.10

6.52

23.66

0.30

7.83

3.06

Long- only Funds

Over $20 million

Average AUM (in $bn) Hedge Funds Average AUM (in $bn)

Given that the recent financial crisis has made investors and asset managers re-think their attitude towards risk, we investigate further whether the amount spent on risk management in 2010 has increased relative to previous years. Figure 22: The Change in the Investment in Risk Management Relative to Previous Years 22a: Long-only Funds

Last 5 years

76.6%

23.4%

Last 3 years

76.7%

23.3%

Last year

75.6% 0%

20%

24.4%

40% Yes

60%

80%

100%

No

22b: Hedge Funds

Last 5 years

64.7%

35.3%

Last 3 years

64.7%

35.3%

Last year

64.7%

35.3%

0%

20%

40% Yes

35

60% No

80%

100%

As seen in Figures 22a and 22b, just over 3/4 of long-only firms in our sample and just under 1/3 of hedge funds have increased the amount that they spent on risk management compared to the last year, the last three years and the last five years. Nevertheless, this trend points to an increasing focus and awareness of the importance of risk management, and indicates that firms have begun to address at least some of the issues regarding additional resources to enhance their risk management capabilities. Even though this is the case for some of the surveyed funds, there is still nearly a quarter of long-only and over a third of hedge funds which have made no increase in investment in risk management at all. One possible reason why hedge funds have not increased expenditure on risk management as much as long-only firms is that they were already more cautious in terms of risk, finding less need to improve and invest, compared with their long only counterparts. To evaluate whether the recent financial crisis has changed the general attitude towards risk in long-only funds and hedge funds, we investigate whether parameters we have used as the determinants of risk in this survey, such as liquidity, size, turnover, etc. are considered on a more frequent basis than in the years during and before financial crises of 2008. Figure 23 reveals that majority of the funds became more diligent in testing risk parameters.

36

Figure 23: Has the frequency of testing risk parameters increased over the last one, three and five years? 23a: Long-only funds

Last 5 years

77.7%

22.3%

Last 3 years

77.7%

22.3%

Last year (2009)

77.1% 0%

20%

22.9%

40%

60%

Yes

80%

100%

No

23b: Hedge funds

Last 5 years

70.6%

29.4%

Last 3 years

70.6%

29.4%

Last year (2009)

70.6% 0%

20%

29.4% 40%

Yes

60%

80%

100%

No

Specifically, over three-quarters of long only firms surveyed have increased the frequency at which risk parameters in this survey are checked compared to previous one, three and five years. Similarly, the hedge funds surveyed show that while 70.6% have seen an increase in risk management activity over the last one, three and five years, 29.4% not seen an increase in risk management activity over the last one, three and five years. The findings in this section bring to light the fact that hedge funds did not change their attitude towards risk management as much as long only asset managers. However, regardless of this, it should be noted that the turmoil in financial markets that started at the end of 2008 has increased the importance of risk management to investment managers overall.

37

4.7. Relationship between companies’ performance and risk management To assess whether the amount spent on risk management is related to the performance of the fund, we run the following cross-sectional regression:

Performancei

ai

bi ASi

i

, i 1.......130

Where Performancei is expressed as the rank of fund i obtained as weighted average 12 month absolute return for that fund. Note that some of the institutions in our sample are hedge funds or privately owned, so the rank data is available for 130 of the 200 finds surveyed (where 1 is the highest and 130 is the lowest ranked fund). AS i is the amount spent on risk management. Note that in our survey the mount spent on risk management is grouped in the following categories: „$0 - $5mn‟, „$10 - $20mn‟ and „above $20mn‟. For the purpose of this model we classify each $5mn as a unit, so that „$0 - $5mn‟ takes value of „1‟, „$10 - $20mn‟ the value of „3.5‟ and „above $20mn‟ the value of „5‟. Table 4 lays out the result. Table 4: Relation between Performance Rank and Amount Spent on Risk Management Coefficient

t-statistic

Intercept

71.85

10.68***

AS

-2.20

1.10

R-squared

0.009

Note: *** indicates significance at 1% level

A negative sign on the AS coefficient in the cross-sectional regression shows that funds that have spent more on risk management should expect to be ranked better in the performance rankings. However this result is not significant the conventional levels of statistical significance.

5. Conclusions This paper provides a comprehensive survey or risk management practices in 200 active European equity asset management firms, both long-only and hedge funds. Our analysis indicates that areas for improvement are many, which is of particular 38

relevance for long only funds. Specifically, over 70% of the funds in the sample resort to the same risk management system and many long only funds do not examine some relevant types of risks (such as size or style risk). In both long only and hedge funds, we find that risk managers are taking on additional roles and lacking independence and that senior management is not well represented in the risk area. Further, long-only funds in particular do not revise frequently enough the top/bottom holdings, among other things. Further, we document that allocation of resources to risk management relative to company size is rather low. Smaller funds in our sample spend comparatively less on risk management than larger funds, which is to be expected. Nevertheless, our study shows that those funds that spend more on risk management are more likely to be ranked higher in the performance league tables. Overall, we find that hedge funds tend to be more risk aware than long only institutions.

As a consequence of financial crisis, the paradigm of poor risk management in European equity funds seems to be shifting as more funds appear to spend more effort to improving their risk management resources. Further research may confirm whether the trend is likely to continue in the future.

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Appendix Questionnaire: 1. Which Risk Management tool do you currently use? Barra AllegroDev Mega Other: Specify: 2. How often do your Portfolio Managers use the system? Daily Weekly Monthly Quarterly Semi-annually Other: Specify: 3. Is your Institution characterized by being predominantly: Long only Hedge Fund Other: Specify: 4. How frequently does a Risk Manager meet with the Portfolio Manager to discuss risks within a portfolio? Daily Weekly Monthly Quarterly Semi-annually Other: Specify:

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Section – 5.1. to 5.5 How often do you analyse the following parameters to detect the risks within the portfolio? Please select from: 1= very frequently; 2= frequently; 3= rarely; 4= never; 5= not applicable

5.1. Portfolio Liquidity Number of days to liquidate portfolio Number of days for the institution to liquidate portfolio Sector weight position vs. previous month Sector weight position vs. previous quarter

1-2-3-4-5 1-2-3-4-5 1-2-3-4-5 1-2-3-4-5

5.2. Active Positions Over quarter Overweights vs. benchmark Underweights vs benchmark Ex-Ante Tracking Error (%)

1-2-3-4-5 1-2-3-4-5 1-2-3-4-5

5.3. Country Positioning Summary Country breakdown vs previous quarter Sector weight position vs. previous year Country relative weights

1-2-3-4-5 1-2-3-4-5 1-2-3-4-5

5.4. Top 10 / Bottom 10 Bets since Portfolio Tenure Cumulative Contribution of top 10 1-2-3-4-5 5.5. Quarterly Stock contribution Relative contribution for Top 20, Bottom 20 Active Money vs. Beta

1-2-3-4-5 1-2-3-4-5

6. Cumulative contribution from Stock selection: breakdown by market cap market cap distribution

1-2-3-4-5 1-2-3-4-5

7. How frequently do you analyse the cash position? Daily Weekly Monthly Quarterly Semi-annually Other: Specify:

1-2-3-4-5 1-2-3-4-5 1-2-3-4-5 1-2-3-4-5 1-2-3-4-5

8. How often do you analyze the Emerging Markets Relative Bet to index 1-2-3-4-5 46

9. How often do you analyze the portfolio turnover? Daily Weekly Monthly Quarterly Semi-annually Other: Specify:

1-2-3-4-5 1-2-3-4-5 1-2-3-4-5 1-2-3-4-5 1-2-3-4-5

10. How often do you analyze the portfolio performance vs. peers? Monthly 1-2-3-4-5 Quarterly 1-2-3-4-5 Semi-annually 1-2-3-4-5 Other: Specify: Other questions: 11. How often do you analyse the following parameters to detect the risks within the portfolio? Active Money 1-2-3-4-5 Stocks Outside the Benchmark 1-2-3-4-5 Tracking Error 1-2-3-4-5 Beta: % of TE from Top 10 stocks How much relative performance comes from Beta

1-2-3-4-5 1-2-3-4-5

12. How often do you analyze the following risk decomposition parameters? Stock Specific Risk 1-2-3-4-5 Country Risk 1-2-3-4-5 Industry Risk 1-2-3-4-5 Risk Index 1-2-3-4-5 Currency Risk 1-2-3-4-5 Other – Specify: 13. Sector Top 10 Bottom 10 Risk Contributors: as Percentage of Tracking Error

1-2-3-4-5

14. Countries – Top 10 Risk Contributors: as Percentage of Tracking Error

1-2-3-4-5

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15. How often do you analyze the following risk contributors as % of tracking error: Volatility 1-2-3-4-5 Size 1-2-3-4-5 Momentum 1-2-3-4-5 Value 1-2-3-4-5 Liquidity 1-2-3-4-5 Financial Leverage 1-2-3-4-5 Growth 1-2-3-4-5 Tail Behaviour 1-2-3-4-5 16. Do you use Style Research Ltd. tool? Yes – No Other – Specify If Yes 17. How often do you use the above system? Daily Weekly Monthly Quarterly Semi-annually Other- Specify:

1-2-3-4-5 1-2-3-4-5 1-2-3-4-5 1-2-3-4-5 1-2-3-4-5

18. Who has the final decision regarding changes to the portfolio when the portfolio is outside the risk parameters? (please tick appropriate box) CIO Head of Equities Risk Manager Portfolio Manager Other –Specify Risk Management Process 19. How many people are in your Risk Management Team? (please tick appropriate box) 1-5 6-10 10+ 20. Does your Risk Manager accumulate other roles? (please tick appropriate box) Yes No

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21. Who does your Head of Risk Management report to? (please tick appropriate box) CIO Investment Risk Oversight Committee Other – Specify 22. How much do you spend on Portfolio Asset Risk Management on an annual basis? (please tick appropriate box) Below $5mn Between $10 to $20mn Above $20mn 23. Has this amount increased vs: (please tick appropriate box) YES Last year Last 3 years Last 5 years

NO

24. Are the above parameters within the Survey checked now on a more frequent basis than in the last: (please tick appropriate box) YES NO Last year (2009) Last 3 years Last 5 years

49