The asset management industry has become more complex over recent years. Organizations that may have focused a few years ago on delivering one or two similar products constructed in one location to a single, homogenous group of clients have evolved into true multinational enterprises. Portfolio “manufacturing” may take place in a number of “factories” around the world, and in each location different styles and variations of the product line may be developed. Particularly in larger asset management organizations, manufacturing competencies are kept distinct from the skills required to develop an efficient distribution capability. Portfolio distribution is also likely to be a multi-location activity, and in each location a variety of different channels may be employed to reach clients.
In many regards the modern financial services firm is as organizationally complex as any large, industrial, multinational company. However, there are two clear differences between a traditional multinational corporation and a modern asset management firm. The asset management firm, despite the increasing use of technology, is still highly dependent on individual contributors. It is the human capital and intellectual property that derives from creative individuals operating in a challenging and stimulating environment that typically underlies and drives the investment and distribution strategy of these organizations. Moreover, the investment product is under strict regulatory oversight. At the factory, prudence and fiduciary standards are key operating constraints. In the distribution network, securities laws govern the transparency of the sales process. This regulatory environment, at least historically, imposes a structure, which has forced significant human intervention. In many instances it is as if each product and sales effort is individually handcrafted for the ultimate client.
With so many moving parts, the management and control of a modern asset management firm is enormously complex. It is necessary to efficiently coordinate intelligent, motivated individuals, who in many cases represent the true value of the organization, to execute an intricate and sophisticated process. These individuals must retain some scope for personal challenge and reward, while the organization overlays a structure for achieving stability and growth to ensure product quality, at the same time delivering a return on capital for the shareholders.
One solution to the problems of organizational management employed most often in traditional multinational corporations is the development of an enterprise-wide management information system. Such a system integrates information flows from the manufacturing and distribution processes, tracking such statistics as units produced by location per product, inventory, unit costs, and margins, and aggregates them by, for example, business unit, division, and the entity as a whole. The system acts as a monitoring device, alerting management to possible shortages in inventory as well as serving as the basis for business strategy and profitability decisions.
The analogy for the asset management firm is straightforward. The product is the investment portfolio and clearly such statistics as the amount of assets under management, fee schedule, and historical performance are relevant. In addition, the portfolio’s overall risk and the portfolio’s likely deviation from its benchmark, in terms of tracking error or residual risk, are important, not only from a quality control point of view but also to satisfy regulatory requirements. These statistics should be aggregated over similar product lines, business areas, and asset classes, and, eventually, all portfolios to give a comprehensive view of the investment integrity of the entire firm. This description, when linked with the product fee schedule and product cost information, can then be extended to provide a comprehensive view of the enterprise’s business risks and prospects.
Where Problems Can Arise
There are many good examples of how an incomplete knowledge of aggregate risks can lead to inefficiencies or worse. Three broad classes of problems can arise from a failure to manage aggregate risk:
o A potential compounding of unintended bets and uncompensated exposures to risk.
o Unwarranted overdiversification or concentration.
o A misallocation of resources. In an organization operating a number of different portfolios, a single source of risk can impact the portfolios underlying many of the products offered, with a huge potential impact on the overall assets. This is true in a domestic as well as a global context.
For example, the past few years in global financial markets have clearly shown that volatility flows around the world, and that events in a single market can have important effects in a global context. Recent specific examples of these phenomena relate to global managers with strong cultural tendencies to a focused style, such as value managers, underperforming throughout their asset base. Without aggregating portfolio holdings and critically examining their sensitivity to risk factors, no asset management executive can be certain of the bets that are being made. Without knowing which bets are being made, they obviously cannot be monitored nor managed. Moreover, the decision-makers cannot be reassured that the bets in aggregate are likely to be compensated by returns sufficient to justify their risk.
A lack of coordination among multiple managers can lead to three potentially undesirable outcomes. A series of unintentional small bets can compound into an unwarranted large bet, leading to an unjustified overconcentration in the aggregate portfolio. In contrast, without coordination, portfolio managers may intentionally take a similar bet–for example, towards value stocks worldwide–leading to an aggregate position that is far too large and an overconcentration in the total portfolio.
The opposite, overdiversification, is also a danger. Here, conservatism tends to eliminate all bets, with the aggregate portfolio approximating an index fund without the possibility of superior performance. For a fund of funds or a plan sponsor portfolio, active management fees go unrewarded, while for an asset management firm the possibility of eye-catching performance is eliminated together with any justification for management fees.
The Big Tradeoff
Modern financial theory is centered on the goal of maximizing a risk/reward tradeoff. This objective applies just as much to the enterprise as a whole as it does to an individual portfolio, where quantitative managers in particular have long used analytical tools to ensure that an asset’s contribution to portfolio risk is commensurate with its contribution to expected portfolio return.
A similar paradigm applies to a fund of funds, in terms of the component portfolios; a plan sponsor, in terms of the managed subportfolios; and an entire asset manager, in terms of the component products. Just as the success of an individual portfolio manager is tied to the performance of the portfolio and its risk/reward tradeoff, so the long-term success of an entire asset management firm is tied to the combined performance of all the products offered and their total risk/reward tradeoff.
A comprehensive view of aggregate risks enables an asset management firm to avoid taking unintended bets, ensure optimal diversification at all times, and allocate resources appropriately through accurate assessment of risk/reward tradeoffs. It is therefore desirable to develop consistency between the analysis on a potentially small set of assets viewed by a single portfolio manager and the aggregated analysis on the entire enterprise viewed by senior management. Indeed, an effective enterprise-wide risk system requires a robust methodology that provides accurate and unbiased risk forecasts across multiple asset classes.