Model Delivery is Risky Business, According to Manager Survey

Most investment managers believe that the risks associated with communicating model changes to sponsors are significant and have the potential to result in negative impact to their firms. This was one of the results of a survey done by Dover Research as reported by Jean Sullivan at the Financial Research Association’s 9th Annual Managed Account Summit, which took place in Boston last month.

Jean reported that model managers support an average of 6.5 model platforms each, with some managers supporting as many as 20 different sponsor platforms!

47% of managers surveyed say that they support fewer than 5 platforms, 37% support between 5- and 10 platforms and 17% support more than 10. These additional linkages can lead to elevated risk, Jean warned.

Jean told us that every investment manager that Dover spoke to is concerned that sponsors won’t be able to implement their trade instructions accurately. This is complicated by the numerous proprietary communication infrastructures developed by sponsors with many variations existing on multiple dimensions such as different delivery mechanisms (email, fax, web portals) and different messaging formats.

Sponsor Trading Constraints Are a Concern

A big area of concern for managers is trading constraints, Jean noted, due to the following issues at sponsor firms:

• limitations in data formats
• sponsor weight and volume restrictions
• basis point limits
• inability to implement price limits
• inability to put securities on hold for more than 30 days
• constraints on the number of trades
• inability to implement international strategies

Three Types of Model Risk

Investment managers in the Dover survey identified three different types of potential risks that arise from model delivery:

1. Reputational – defined as performance dispersion due to the inability of the sponsor to implement the manager’s model. This could be caused by a manager wanting to make an intra-day model change, but can’t because the sponsor doesn’t support it.
2. Best Execution – defined as the inability of the sponsor to achieve best execution due to trading restraints. Trade rotation processes influence best execution, because there is no automated feedback regarding trade execution, so the manager doesn’t know when their trades have been executed. It could be due to sponsor firms competing against each other in the market. It could also be due to delays in communicating model changes.
3. Operational – defined as the increased risk of errors due to the manual nature and inconsistency of the current model update processes. For example, if the manager’s operations staff makes an error in a model change, the manager is then responsible for making sponsors and their clients whole, even if the mistake isn’t discovered until months later. This is an area of significant cost and concern for investment managers.

The managers were then asked to rate which of these risks are “significant”. 50% selected operational, 45% said best execution and 17% chose reputational.

Due to the many issues arising from model communication, many managers are starting to build out their own model validation processes to reduce manual error and monitor best execution at the sponsor, according to Jean. Also, 67% of managers believe that a centralized model service that provides a standardized method to implement and monitor trade rotation would reduce risk.

The Model Management Exchange (MME) from DTCC is such a centralized model service, Jean said. It is secure and redundant communication system with integrated audit trails incorporating validation and confirmation features. It can also facilitate the trade rotation process, but this would require sponsors to send their execution data to DTCC.

The industry should take the opportunity to do something now to address the risks surrounding model delivery, urged Jean. I agree that something should be done, but what exactly?

Before anything can be done, both sponsors and managers should agree that they must work together to solve the problems. The risks expressed by managers are due to a complex mix of factors and cannot be easily mitigated and especially not in isolation.

A centralized model hub, such as the DTCC’s Model Management Exchange (MME) or Fiserv’s Model Information Exchange (MIX), which is planned for 2012 release, could help, but only if they achieve critical mass and then they can only help on the communications side. Risks that are due to specific sponsor’s model policies (i.e. Inability to implement price limits, trading windows) or manager operational issues (manual errors) will still exist no matter how the model information is delivered.

What Went Wrong in Managing Risk and How Can We Do Better?

This is a summary of a session from the FRA’s Performance & Risk Measurement Symposium that was held in Boston on April 23-24, 2009.

Speaking in this session was James E. Hollis, CFA, Managing Director of Cutter Associates.

Jim provided a well-researched overview of the recent financial crisis as well as some tangential, but interesting facts about the economy.

Jim quoted from an article by Nassim Taleb, “Ten principles for a Black Swan-proof world“:

People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

While Jim used this point to highlight the financial industry’s role, the author was in fact, indicting everyone who was involved (universities, regulators, central bankers, government officials, and various organizations staffed with economists).  Members of Congress who facilitated the crisis, such as Rep. Barney Frank, D-Mass., have paid no penalty and suffered no punishment at all for their negligence and I brought this up to Jim in the Q&A. (Take a look at this article by the Boston Globe’s Jeff Jacoby, Frank’s fingerprints are all over the financial fiasco for a terrific overview of the Frank’s role in the economic debacle of the century.)

Performance measurement without risk is meaningless, Jim cautioned. “No attempt to measure investment performance is complete without measuring the risk taken to achieve the result.” (from Risk Adjusted Investment Performance Measurement by Financial Counselors of VA)  How many smart investors ignored this rule when they overloaded on credit default swaps and CDO’s?   They also forgot that “the market risk of an investment cannot be reduced by diversification since it is shared to a greater or less degree by all investments in the market.”  (ditto)  Performance professionals need to have a solid understanding of risk management, according to Jim.

Where has all the bailout money gone?  Jim pointed out that most of the $80 billion in bailout money provided to AIG went into the pockets of global banks such as Goldman Sachs, JPMorgan Chase, Société Générale and Deutsche Bank.  The burning question is why were AIG’s trading partners, including foreign banks, let off the hook while US taxpayers footed the bill?  (see Inquiry Asks Why A.I.G. Paid Banks in the New York Times for the gory details)

I disagree with Jim when he said that the roots of the crisis goes back to the Reagan/Thatcher era of laissez-faire attitude towards regulation.  My opinion is that it was government intervention in the markets that encouraged the poor investment decisions that led to the credit crunch.  Fred L. Smith Jr. from the Competitive Enterprise Institute summed it up quite well when he wrote the following to the WSJ:

A driving force behind all this has been radical egalitarianism — the idea that something that can be afforded by some should be made available to everyone… Under the egalitarian promotional housing policies of the last few decades, banks became institutions that would loan you money even if you were unlikely to be able repay it. The moral hazard problems created by our bipartisan egalitarians (the Community Reinvestment Act, the mandates on Fannie Mae and Freddie Mac) enticed far too many Americans into purchasing homes priced beyond their means. There is a critical distinction between the democratizing tendency of the market and the coercive egalitarian policies of politics.

I’m a supporter of the subjective theory of value that asserts that the seller and buyer of products or services are the only ones able to determine the value.  When the government decides to impose prices on the marketplace, only disaster can result.

Jim next presented some interesting aspects of the Bernie Madoff scandal.  He referenced a document submitted to the SEC in November 2005 (three years before he admitted to his Ponzi scheme), which was obtained by the WSJ, The World’s Largest Hedge Fund is a Fraud.  The author of the document was Harry Markopolos, an independent fraud investigator and derivatives expert, who originally alerted the SEC to Madoff’s scam back in May 1999!  The fact that the SEC has been ineffective and bumbling throughout both Democratic and Republican administrations shows what a low priority it was for both parties to hire competent staff and provide the necessary funding.

Proposed Changes to GIPS Standards

Last Thursday and Friday, I attended the Financial Research Association’s Symposium on Performance and Risk Measurement in Boston.  There were a lot of informative sessions and I took almost ten pages of notes, so I should have enough material for a bunch of posts.

Unfortunately, I wasn’t able to travel on Wednesday evening, so by the time I arrived at the hotel around 10:15, I had missed the first session, which was given by Holly Miller from StoneHouse Consulting.  I’ll try and speak to her this week and see if she can give me a summary or if she has a blog posting I can link to.

The next two sessions reviewed the upcoming changes to the GIPS standards (called the GIPS 2010 Exposure Draft, which you can find here) and were hosted by Karyn Vincent, president and founder of Vincent Performance Services.  I first met Karyn at the FRA Tech & Ops Conference in Miami back in February when I was lucky enough to find myself sitting next to her at lunch.  I found her to be extremely knowledgeable about all aspects of performance measurement, so I was looking forward to these two sessions.

There was also a roundtable to provide some pros and cons for each proposed change and encourage discussion.  The panelists were:

• Todd Juillerat, Global Head of Performance, State Street Global Advisors
• Jason Millard, Beacon Verification Services
• Steve Riordan, President, Riordan Consulting
• Mike Savage, Director of Performance Distribution, Sungard

These sessions provoked some lively comments and discussions between the panel and the audience.  Karyn went through many of the proposed changes to GIPS for 2010 and gave the rationale that the committee used to come up with each change.  I won’t go over every single change, since you can easily do that for yourself on the GIPS website.  I’ll just review some of the highlights:

4.A.29 Firms will be required to disclose the 3 year annualized ex-post standard deviation of the composite and benchmark.

This change provoked the most responses from the audience.  While everyone agrees that performance without risk is meaningless, not everyone believes that standard deviation is an effective measure of risk.  Committee members from European countries were pushing for multiple risk measurements to be used, while US members wanted less, so presenting standard deviation was the compromise.  The EU members don’t feel that this change goes far enough in bringing risk into the disclosure process.  The committee was just trying to get risk in there some way, according to Karyn.

Jason said that he “hates this one” for a number of reasons, one of which is because the time period is arbitrary.  Also, the use of standard deviation assumes you have a normal distribution, which often isn’t the case for most portfolios.  Todd countered by saying that a compromise is, by definition, a sub-optimal solution, so people on both sides will take issue with this change.

4.A.5 FIRMS MUST disclose the presence, use, and extent of leverage, derivatives and/or short positions, if material, including a description of the frequency of use and characteristics of the instruments sufficient to identify risks.

The key point here, noted Todd, is that this only applies to material positions only and “material” is not defined by the standard.  Each firm must make their own definition of “material” when evaluating their holdings in light of this change, Karyn stated.  Mike was concerned about the time and effort required for firms to document all of their leveraged positions along with descriptions of the use.   “Where do you stop?”  He questioned how much time and effort will be required to create and maintain this documentation.  Firms don’t have to track the percentage of short positions, only an answer of “yes” or “no” that they’re used is sufficient, Karyn clarified.

3.A.1  All actual discretionary PORTFOLIOS MUST be included in at least one COMPOSITE.

The change here is the deletion of the words “fee-paying” before discretionary, such that now all portfolios, both fee-paying and non-fee-paying, must be included in at least one composite.  Non-fee-paying portfolios would include proprietary assets. This sparked some discussion since principals might be more aggressive with their own funds and including them in composites with customer portfolios might skew the performance.  However, it was pointed out the assumption that all assets in the same composite are managed in a similar manner.  Therefore, any proprietary portfolios that are managed differently, should be put into their own, separate composite.

Section III – Verification, The GIPS standards RECOMMEND that FIRMS be verified.  1. VERIFICATION MUST be performed by a qualified independent third-party.

This proposed change also requires firms to disclose whether or not they have been verified.  While the verification requirement is voluntary, some smaller firms may cite the cost of hiring a third-party verifier as a road block.  Cost shouldn’t be used as a basis for non-verification, said Mike.  Also, in the current environment of heightened regulatory scrutiny, any firms that claim GIPS compliance will be double-checked by regulators.

Karyn put out a call for feedback from all firms on the GIPS 2010 Exposure Draft.  The public comment period will last until 1 July 2009.