Dyman Associates Risk Management: Is

Your Money Safe?

Is Your Money Safe? Risk Management Blindspots That Cost Investors Dearly

Both retail and institutional investors who have survived one or more economic recessions
have learned that they cannot select their money managers solely on a demonstrated
stream of at or above benchmark returns and that they need to include the underlying risk
of their investment portfolio in the formula that calculates expected future value. However,
the risk denominator in portfolio management analytics may be underestimated or
misestimated because of the following three industry problems:

1. The traditional view of risk is disaggregated

The traditional view segregates risk into market, credit and operational. In most
organizations, both public corporations that issue equity and debt to investors and
privately-held asset managers that oversee investors money, the various aspects of risk
are managed separately. For example, in some typical organizational structures, the
Investment Officer is responsible for market risk; the Treasury Officer or CFO for credit risk
and the COO for operational risk. Each analyzes and synthesizes risk separately and
reports his findings to the Board or Management Committee, leaving them baffled to make
sense of the holistic picture. However, risk is not additive or linear and often hot spots in
one area may cause undetected issues in other areas.

Market, credit and operational risk were interrelated in one of the most notorious
examples of risk mismanagement AIGs failure to meet its liquidity obligations which led
to $170 billion government bailout. AIG was heavily involved in writing CDS with its
exposure at the height reportedly reaching $440 billion (market risk), which exceeded
what the company could pay in claims when the MBS it insured defaulted leading to a
liquidity crunch (credit risk). Additionally, there were signs of inherent operational risks:
AIGFP was a minimally regulated and separate hedge fund that leveraged the credit rating
of the holding company to place big bets with little reserves. Each one of these issues
separately did not pause crash the car risk, but in aggregate the market, credit and
operational risk factors of AIG could have been lethal to the company and the economy safe
for the subsequent government bailout.

2. Regulators are approaching the industry reactively

Significant regulatory tightening ensued after the 2008 mortgage crisis. According to some
critics, regulators may potentially be looking at risk far more reactively by focusing on the
problems that have already manifested than proactively identifying new risks that could
cause the next business failure. For example, the Financial Stability Oversight Council
(FSOC) so far designated three US financial institutions as Systemically Important Financial
Institutions (SIFIs) GE , Prudential and AIG and imposed on them increased capital
requirements. However, the FSOC does not consider large asset managers to be SIFIs.
There is some merit to the logic that asset managers do not require as strong of a balance
sheet since they do not own the assets they manage and pass through the downside risk to
their investors. Yet, it could be argued that the asset managers aggregate risk and that
their investment processes and technology infrastructure pause systemic risk. For
example, over a trillion dollars of passive investments including the iShares brand are
managed on Blackrock s technology platform Aladdin. It is not hard to foresee the dramatic
impact of a major failure of Blackrocks platform on the US and global economy.

3. Operational risks is not adequately represented

To manage market risk better, most investors are well aware of basic portfolio hygiene
principles including the value of diversification, the importance of looking at volatility
driven asset correlation, rebalancing, the criticality of subtracting leverage when assessing
quality alpha, the value of protecting for inflation through IL bonds or inflation-hedging
assets such as real estate. I would argue that operational risk is as big if not a bigger driver
of financial loss as market risk. According to Phillipa Girling, a leading expert on
operational risk and author: operational risk in the headlines in the past few years is hard
to ignore: Notorious examples include egregious fraud (Madoff, Stanford), breathtaking
unauthorized trading (Socit Gnrale and UBS), shameless insider trading (Raj
Rajaratnam, Nomura, SAC Capital), stunning technological failings (Knight Capital, Nasdaq
Facebook IPO, anonymous cyberattacks), and heartbreaking external events (hurricanes,
tsunamis, earthquakes, terrorist attacks). (Operational Risk Successful Framework).
Inadequately managed operational risk costs investors, corporations and tax payers
billions of dollars: Madoffs pyramid reportedly cost investors $18 billion and the 2008
government bailout cost taxpayers $700 billion. (New York Times Archives)

If the impact of operational risk is undoubtedly large, why do otherwise savvy investors
often disaggregate or even completely miss operational risk from the overall expected
value analytics of their portfolio and inadvertently accept more risk than they are
comfortable with? Part of the problem stems from a lack of a well established methodology
to clearly quantify operational risk and integrate it into portfolio management.

Imagine creating a unified industry-sponsored score for operational risk similar to a credit
score or Moodys bond ratings, which takes into consideration the fundamental elements
of operational risks people, process, technology, and external events, and quantifies them.
That score would then be clearly available for investors along with the returns and market
risk of the portfolio leading to a far more accurate valuation. Significant progress toward
accountability and transparency could be made if operational risk were to be demystified.

How can investors make safer investments?

What could investors do in an environment of confusing regulatory requirements and
limited transparency around operational risk? For starters, Investors can raise their
awareness and employ alternatives to address the information asymmetry in the following
ways:

1. Select asset managers that demonstrate commitment to operational risk
management

Certainly some asset managers understand and are willing to invest in operational
excellence and risk management. For example, in the 2014 Review of the Asset
Management Industry, the Boston Consulting Group provides an overview of the shadow
model where an asset manager can use two counterparties to manage their middle and
back office. At Bridgewater Associates, I co-led the implementation of such a model where
the firm aimed to create greater transparency, switchability and stay ahead of the
regulatory bodies by outsourcing its back and middle office to both BNY Mellon and
Northern Trust. FundFire published an article, Bridgewater Divides Industry with Latest
Deal, describing the benefits and open questions about the model. It is still early to say
whether the industry will embrace this model more broadly. Similarly to gain an
operational excellence edge, Citadel and Tudor invested in a custom-built straight-through
processing systems that integrate the trading platforms with the post-trade processes
creating greater transparency and reliability. Both are aiming to commercialize their
technologies and make these available to smaller money managers who may not be able to
afford a large in-house technology development team.

More About the Article