Re-engineering Risk

Risk and volatility are the new normal for today’s investment managers. In a fast-paced and highly changeable environment, a strategic yet adaptable approach to risk management has become one of the defining characteristics of leading asset managers.

An increased focus on risk comes at a time when most asset managers see new threats emerging on multiple fronts. According to a State Street survey, 92 per cent of asset managers expect regulatory risk to increase significantly over the year ahead.1 Well over half also foresee significant increases in operational risk (67 per cent), and market risk (61 per cent).

Mastering such a broad range of challenges requires a more holistic approach to risk management. This means risk can no longer be confined to the middle office. Instead, risk management becomes a c-suite concern and one that influences everything from the markets an asset manager choses to operate in to the way it designs, markets, and distributes its products.

Regulatory Risk And The Drive For Transparency

Of all the risks on the horizon, it is understandable that regulatory risk should loom largest in the survey. Over the past six years, financial services institutions have been hit by hundreds of regulations. The range of regulatory requirements is huge, but what many of these initiatives have in common is the desire to create greater transparency in the investment industry. For example, after a series of mis-selling scandals, regulators are eager to ensure investment products are well aligned with the needs of investors.

This means that asset managers must be able to design products that are tailored and targeted to the right investors – whether they are high-net-worth individuals, less sophisticated retail clients, or major pension funds. They must work harder to communicate what a product does, as well as its associated risks.

Asset managers must also take steps to explore their distributors’ information needs. Even in situations where the asset manager has no direct contact with the end-investor, the regulator could rule that the asset manager is accountable. So the overall effect of the regulators’ demands for increased transparency will be to force asset managers to think much more clearly about the different risk issues that affect every aspect of their products and the way they are marketed.

Solutions For A Volatile World

Regulators aren’t the only ones demanding new strategies to manage risk. Many investors had their fingers burnt at the time of the financial crisis and are determined to find better ways to manage market risk and volatility. One of the defining experiences of the financial crisis was that investors discovered their supposedly diversified portfolios were, in reality, comprised of strongly correlated assets. It was a painful lesson. The current popularity of multi-asset solutions – a trend underscored by our survey – is partly about using a broader range of ‘de-correlated assets’ to diversify their portfolios more effectively. These include alternatives such as hedge funds, private equity, and real estate.

Multi-asset solutions can help to reduce volatility, but they create new challenges for the asset manager. Risk considerations need to inform every aspect of the manager’s investment strategy and approach to portfolio construction. At the same time, asset managers need new tools to be able to analyze and report on risk holistically across a more diverse set of asset classes. Four out of five asset managers in the survey (81 per cent) say that risk analytics will be a priority for investment over the next three years.

On a broader level, there is a need for informed debate about the role of innovative products and strategies that could help manage ongoing volatility in the market. For example, are derivatives too complex for retail investors or an important part of any investor’s portfolio given their potential to hedge downside risk and manage volatility? Opinions differ and regulators will add their voice to the debate.

Perhaps a better approach is to ensure that asset managers who use derivatives are forced to be explicit and transparent about their presence when marketing and distributing their products. The main principle is that the asset manager must explain the consequences and potential benefits of these tools in accessible language.

Capacity For Change

Asset managers operate in a risk environment that is constantly evolving. As regulators around the world race to respond, asset managers need to be smart and agile enough to cope with new challenges and new demands.

Achieving a more strategic approach to risk will require asset managers to invest in new expertise, as well as innovative technology tools and infrastructure. Many asset managers will also turn to service partners to alleviate the burden of these multiple challenges. Doing so will allow them to focus on their core strategic purpose – delivering strong performance net of fees across different channels and geographies.

The challenge of managing in a volatile and heavily regulated world will cause leading asset managers to re-engineer their products from conception to final delivery. It is a shift that will require board-level focus, as well as investment in talent and technology. But asset managers that strike the right balance on risk will be agile and resilient enough to ride out volatility, while at the same time creating clear value for their clients.

Jane Mancini is State Street’s head asset manager sector solutions for the Americas.

1. The research presented in this report is based on a global State Street survey of 300 senior executives at asset management firms. The State Street 2014 Asset Manager Survey was conducted by FT Remark in April and May 2014. Respondents were equally distributed across North America, Europe, and Asia Pacific.