“Hedge funds for awhile didn't have to manage their risk, so they didn't invest in risk systems,” said Debbie Williams, head of marketing and business development at R² Financial Technologies, now part of S&P Capital IQ. S&P Capital IQ provides multi-asset risk systems for the buy-side, something which they haven’t really had, she added. Capital IQ acquired R² Financial Technologies in February 2012 to expand its strategy of providing its a portfolio and enterprise risk analytics to the financial services marketplace. S&P Capital IQ provides multi-asset real-time data and analytics to institutional investors, investment and commercial banks, wealth managers, corporations and universities globally.
When hedge funds did have some issues with risk, they yelled at their prime brokers to do something about it. Buy-side firms that did run risk management might have used Riskmetrics or Algorithmics,, while others used Excel, a flexible all-purpose tool not designed for specific tasks like risk management.
“But it’s hard to do intraday decision support [with those tools] because you can’t get the analysis turned around quick enough and you can’t run complex scenarios,” said Williams. “We don’t typically have much competition in terms of head-on features. Instead, we usually compete with a back-office systems that someone is persuading the front office they should use.
Today’s demand for buy-side risk management is also driven by changing investment styles, she added. In the past the buy-side invested in a single asset class -- usually equities.
“Even today the vast majority in numbers and dollars of assets are invested in conventional buy-side equity portfolios, so the big decision is which stock to buy and which to sell.”
Single asset funds face two risks. One, they buy and sell the wrong stocks, don’t perform as well as the S&P, look like idiots and everybody takes their money out and walks away. The other risk is that the fund invests in a selection of stocks that deviates from its asset allocation. BARRA has offered multi-factor equity models which can tell how any portfolio of equites will perform based on a set of factors with risk measurement.
“That breaks down when you buy things that aren’t equities and it breaks if you aren’t just buying and holding -- if you have short positions or hedges, those tools don’t account for them.”
Although hedge funds widely enjoy a reputation for being run by cowboys who will invest in anything as long as the holding period isn’t more than a few minutes, in practice, said Williams, many of them invest solely in equities, long-only or long-short.
Macro funds are more demanding because they follow, or one might argue, create opportunity, like the U.S.-based funds that bet against the housing bubble.
“The other growth area is credit -- long-short bond positions, debt, buying loans and loan portfolios -- the whole gamut of structured finance. That is where a lot of money has gone -- into higher risk, higher reward -- and then the risk tools become more important than they would be for a portfolio manager deciding between Ford and GM.”
While the vast majority of assets under management (AUM) are in conventional funds, the growth is on the more active side. Williams said about $80 trillion is in conventional and only $2 trillion in hedge funds, but hedge fund assets have grown 50x in the last 20 years while conventional asset managers’ funds have only doubled.
Pension funds and insurance funds are looking for higher returns.
“Most assets come through the institutional side , and they can’t just select a fund manager to pick equities and hope that will meet the fund’s liabilities. If you have fixed liabilities not doing well on the asset side of your book, that is fatal.”
Articles in Institutional Investor show that more traditional asset managers, like pension funds, are buying real estate, investing in hedge funds, distressed debt and CLOs again and in hedges for their book, she added.
“We are not going to go backwards where you can succeed as an institutional asset manager just by picking your favorite security or bond and holding it. Risk tools will have to catch up.”
Alternative investment funds, which operate in a very competitive world, use S&P Capital IQ in their sales process.
“We were a little surprised at the requirement we have had for external reporting,” explained Williams. “We built this a as decision support, not necessarily for back office users.”
Where investor relations was something of an oxymoron for highly secretive hedge funds not too many years ago, now funds have to make their results visible to institutional investors.
“There has been a big demand for more externally oriented reporting,” added Williams, “first for investors then for marketing to new investors and soon, I expect, to regulators. One way for hedge funds to to differentiate is performance. But if your money is coming from relatively sophisticated investors, the other way to differentiate will be risk efficiency -- how much risk did you take to generate that performance?”
Williams is looking forward to the next big (also last big) investment trend -- securitization.
“Yes, securitization is coming back and the volume of CLOs were growing at the end of last year.” This time is different, added Williams, sounding like a paraphrase of the book by Carmen Reinhart and Kenneth Rogoff. The new structures are more transparent, investors are doing more due diligence and they have tools like S&P Capital IQ to run analytics against the underlying collateral of any asset-backed security.
“There is a demand for securitization and a demand for yield.” On a macro economic level the yield curve is flat; on a macro demographic view, a pension fund is going to see increased outflows as baby boomers retire.
“Institutional portfolios are looking for other ways to earn money on their assets,” added Williams. “Combine that with a steady supply of assets people want to originate but don’t have the capital to hold on their balance sheets, and you have a willing seller and willing buyer.”
NxR² can price new instruments quickly by drawing on its Numerix libraries or by allowing the client to plug in a Python script using the custom equation editor.
Given new capabilities in the market and increased investor demand for risk reporting, the demand for solutions in this space should continue to grow.
