Our asset management clients are investing in increasingly complex instruments in response to more volatile markets.They need new data management and measurement tools so that they can assess and manage the new types of risk they are taking on, supported by more advanced risk analytics and risk measurement and assessment capabilities.
Four senior leaders came together to discuss this trend, including Xinna Huang, Global Alliances Director at Numerix, Ilja Faerman, Head of Product Strategy at Numerix, Alan McKenna, Global Head of Middle Office Product at Apex Fund Services, and Max Hilton, Managing Director of Apex Risk Technologies.
Xinna opened the discussion: “As volatility has increased, traditional asset managers have naturally looked to widen their investment scope into more complex instruments like derivatives, quant strategies, and private markets but can only do this once they are comfortable that they can assess the risks involved. And that has been a problem, because traditionally the ability to drill down into the multi-level risk parameters that are contained in these more complex investment instruments was only available to investment banks and very large institutions. But this is changing: there is clear evidence that traditional asset management firms of all sizes are trading complex instruments with much more freedom, partly because they can now assess and manage these new risks with new cost-effective tools from providers like Numerix and Apex.”
Derivatives and structured products
The discussion focused first on the use of derivatives and structured products by traditional asset managers. Ilja set the scene: “Derivatives are being used more for hedging currency exposure and in shaping cash flow profiles in liability driven programmes. And those asset managers who are not necessarily investing in derivatives directly are acquiring derivatives embedded in other assets. For example, a portfolio of bonds may now have exposure to CMS spreads, and structured credit like MBS and ABS structures have embedded optionality.”
“A lot of the asset managers that we're working with”, added Alan, “are now investing in structured credit such as MBS and ABS structures, which obviously have embedded optionality as well: the so-called ‘prepayment option’.”
Ilja set out the analytical challenge this poses: “Those investing in these derivative instruments are aware that they need access to a lot of analytical complexity to capture the changing dynamics of these instruments in stress scenarios. Take the example of a CMS spread – it requires advanced modelling to achieve this level of risk management. On top of this, managers need Value at Risk (“VaR”) measures to assess properly how an option behaves in stress conditions and how the stress actually links the prepayment behaviour with other economic factors.”
Quantitative investment strategies
From derivatives the conversation moved on to quantitative investment strategies (“QIS”).
“We are also seeing the emergence of the use of QIS by traditional managers,” said Alan. “Our clients are investing in these vehicles and tailored beta strategies through total return swaps. It is important to be able to look through a quantitative investment strategy to understand the risk you are taking – you need to go beyond standard factors like value. Instead, you need to include volatility targets and target volatility funds. A custom basket can carry a lot of risk management requirements around how to capture all the dynamics of a complex instrument of this sort in your portfolio.”
Private markets
Max moved the talk on to the risk challenges posed by private markets investing. “It's a very exciting time for both private equity and private credit. But some traditional asset managers are still trying to fully grasp how to include these instruments in a holistic portfolio-wide risk management framework. They have to be sure that when they are running historical VaR or Monte Carlo VaR calculations, they are properly capturing all the risks associated with private market instruments. We are still seeing some firms relying on relatively simple proxy assumptions which do not provide an adequate risk management foundation.”
Regulatory change
Xinna widened the conversation to regulation. “So, we can see that market volatility has prompted significant shifts in investment product buying behaviour, and how risk management techniques and technology have had to evolve as a result. Regulatory change has had the same effect.”
Max summarised the landscape. “What we are seeing is a real and growing concern among regulators, driven here in Europe in particular by the CSSF, the Commission de Surveillance du Secteur Financier, Luxembourg’s financial regulator, that mark-to-model valuations are independently sourced and formalised. There must therefore be a documented process behind that valuation. This can be a real challenge with the more complex instruments we have been describing today.”
Finally, Max touched on the vital impact of liquidity regulation. “Liquidity risk management must show that it has the ability to accommodate expectations on market impact and reporting of time to liquidation in different scenarios. Where instruments are complex this becomes much more challenging, but no less necessary. European regulators have been taking the lead here, and we can see, for example, the UK catching up, and [that] this will be a global trend.”
Xinna summarised the conversation: “We are seeing some big changes in the way that our asset management clients are investing and managing risk in response to more volatile markets and tighter regulation. They need new high-quality data management and measurement tools to facilitate those changes. It is exactly for this reason that we at Numerix and Apex have started to work together – so that we can provide those new tools in a cost-effective form. We hope our conversation today has made it clear how important our partnership is in these changing times.”
