Lawrence Davis
INSIGHT 21/01/2020

Culture: Hiding in Plain Sight – Part Four

Lawrence Davis Analyst

Although a subjective concept, culture hides in plain sight and is readily observable if you know how to look. In a series of short pieces, Lawrence Davis, an Analyst on Aurum Research’s Operational Due Diligence team, explains the importance of a hedge fund manager’s culture to investors, the problems in defining and quantifying it, and how we overcome these problems to interpret it during due diligence.

Part 4: Risk Management

Aurum’s Operational Due Diligence (“ODD”) team is distinctly separate from the Investment Research team. However, the two teams’ collective research flows through into investment recommendations made to the directors of the Aurum funds and there is some overlap in the areas they focus on. Risk management is one of these areas, and we consider it to be a strong indicator of the culture being engendered within a business. In this article we are going to focus on how risk culture can be interpreted through review of the existence and enforcement of limits and guidelines; the fund’s portfolio and offering documents; employees’ risk responsibilities and technology.

Limits and guidelines

Firms generally have in place a series of limits or guidelines to reduce excessive risk in the portfolio. These may relate to areas such as gross or net leverage, drawdowns, position sizing and risk allocation. They could be hard or soft limits and vary depending on the strategy and the portfolio manager’s (“PM”) trading style. If a limit is breached, it may trigger action on behalf of the PM or another member of staff to reduce risk. Alternatively, it could be overridden in certain circumstances, with sufficient justification.

If limits are in place but they are set too wide, this could indicate a firm merely wishing to tick the box of having a risk framework to appease a cautious investor base. Limits may alternatively be proportionate but if breached do not trigger any meaningful action on the part of the PM or another member of staff. Either of these scenarios could indicate that the team wishes to operate irrespective of any investment restrictions put in place to protect investor capital. When we perform initial due diligence we establish the limits and guidelines a manager has set themselves to invest the fund’s assets. If a manager strays from their mandate or ignores risk limits and guidelines that have been communicated to investors, this may betray a cultural deficiency inherent within the business.

Notwithstanding the above, a proportionate and regularly enforced set of limits and guidelines are not on their own a sufficient substitute for a manager’s track record in risk management. Before recommending an investment, the team obtains several references on risk takers and examines prior performance to understand how they have risk managed their portfolio in the past. Once invested, Aurum aims to build long term relationships with its managers and over time looks to understand how they manage risk individually rather than expecting every fund to take the exact same approach. If Aurum has been invested with a manager for a long time they may have historically demonstrated a very disciplined approach to investing. Our opinion of a manager’s risk culture may be formed by our experience of them rather than an extensive and prescriptive set of risk controls. Separately to this, controls that are too rigorous may prevent a manager from expressing their ideas properly and could even inhibit proportionate risk taking.

If limits are in place and they are breached, we have observed a wide range of protocols put in place by firms to remedy these breaches. For example, drawdowns beyond a certain amount can in some instances result in automatic termination of employment. This demonstrates a highly strict and unemotional approach to risk management. Other managers may allow PMs the time to work themselves out of a drawdown rather than firing them. These two policies represent two very different types of risk culture, neither of which are wrong but which work for a particular business. They also show us what to expect from a manager in the future.

In Part 3 of this series we discussed the extent to which managers communicate changes in their business to us and how doing so demonstrates a collaborative culture. The risk management policy is no exception to this. If a manager decides to change any key limits they have in place, we would want to be notified of this, ideally in advance or at least very shortly afterwards. This is so we can discuss the appropriateness of the change with our Investment Research team and consider whether this modifies our overall impression of the fund’s risk profile in the Aurum portfolios.

Portfolio composition

How the portfolio looks at any given time might be considered to fall solely within the remit of our colleagues in the Investment Research team. After all, it is one of their responsibilities to ensure a fund is sticking to its mandate. However, at Aurum the ODD team plays an active role in the review of funds’ portfolios both during initial due diligence and ongoing monitoring. When we do this we are primarily looking for indicators that there has been a deterioration in liquidity or any unexpected increases in gross or net leverage. These changes can tell us something critical about a manager’s risk culture.

We will use liquidity as an example. When performing due diligence we review each fund’s offering documents to understand its liquidity profile, and consider whether the investment mandate is compatible with the redemption terms hardwired into these documents. We need to opine early in the process whether these terms are proportionate enough to allow for an orderly liquidation of positions in the event significant redemption requests are received in a short time period.

If the fund’s portfolio appears to show a shift towards illiquidity in any way, the fund may no longer be able to close out positions in an orderly manner and at a fair price if it experienced material redemptions. This shift could be indicated by, for example, larger than usual single position sizes or unlisted securities. If the liquidity profile of the fund has shifted materially without any commensurate change in redemption terms, this could indicate that a manager is ignoring their own risk framework to the potential detriment of investors.

To summarise the above, a cultural weakness may be demonstrated through the changing composition of the portfolio, for example with higher leverage, large concentrated positions or less liquid holdings that do not tie in with a fund that offers investors regular liquidity. If this happens, it is both an investment and ODD concern and underlines the importance of continuous research and operational monitoring.

Risk responsibilities

As we have outlined in the prior instalments of this series, the allocation of specific roles and responsibilities across the firm shows us the priority assigned to different functions. This holds true for risk management. We sometimes do not see start up managers employing their own risk resource. The role of Chief Risk Officer may be held by a multi-hatting Chief Operating Officer, in the same way the Chief Compliance Officer role may be. However, this is not necessarily a red flag for ODD. A relatively simple strategy can be effectively overseen by a multi-hatter who provides input to the PM.

If a PM does not give any risk oversight or authority to another member of staff, it could indicate a lack of trust in the team, or an unwillingness to dilute control.  Whilst the PM should be given the latitude to manage the portfolio how they see fit, ODD advocates for a second pair of eyes from a risk management perspective, acting as a check on the PM’s activity. We also understand whether any other members of the investment or operations teams are authorised to instruct risk-off trades. In certain cases it may be inappropriate for non-investment personnel to have the ability to trade, given the potential blurring of front and back office functions. However, generally we consider that another senior individual with the requisite experience and ability should be able to step in. For example, this would be an important consideration if the PM was indisposed and/or a key person event had been triggered, or if the fund was materially breaching risk limits.

Building on this, if another member of staff does have some degree of authority to step in, we need to think about their character as well as their seniority. Will they have the teeth to stand up to a PM in the event an issue does arise and be able to take decisive action? We can firstly form an opinion on this through meeting with these individuals. Further, we will obtain references from people they have worked with in the past and look to see past examples where they have demonstrated this ability.

There are clear practicalities of other employees sharing responsibility for risk management with the PM. If there are no such arrangements in place this tells us something about a firm’s risk culture, specifically the extent to which a PM trusts their team and is willing for their control to be diluted.

Technology

We do not believe that a hedge fund can be meaningfully risk managed without the use of technology. Technology can facilitate highly effective risk monitoring of a portfolio with automated controls built into Order and Portfolio Management Systems (“OMS” and “PMS”). These controls may prevent certain trades from being executed, or force a manager to take action to reduce risk if certain limits are breached.

Even in the most basic of strategies, we have come to expect that every manager will have implemented some degree of automated risk monitoring and control into their process. How this is designed and maintained will depend on the strategy and a PM’s trading style. For example, discretionary macro funds might be expected to have generous or very wide boundaries for certain factors such as drawdowns or leverage, whilst equity market neutral funds may be constrained by strict built-in limits which cannot be overridden.

Regardless of the strategy, a risk system allows the firm to monitor the portfolio’s composition against a number of metrics including factor exposures, drawdown, leverage, directionality and volatility. The extent to which a manager invests in and uses their risk system, including whether any limits are hard coded into both pre-trade checks and ongoing portfolio management, shows us their intent towards implementing a strong risk framework. As such it can act as a useful cultural indicator.

Conclusion

We believe that the risk management framework lays bare a hedge fund manager’s culture because it encompasses so many different parts of the business. As such it forms an integral part of our due diligence from both an investment and non-investment perspective. Risk management is a broad discipline and the areas we have explored are just four of many. However, we have aimed to demonstrate some of the ways we can use risk to form an opinion on the way a manager runs their business.

As we argue in the first article of this series, culture as a concept can mean different things to different people. This makes it difficult to define and quantify: one cannot pick apart and assess a manager’s culture the same way as a fund’s performance or annualised volatility. It is therefore arguably harder to form an opinion on, and is perhaps something more easily overlooked.

Aurum’s ODD team retains the right to exercise a veto over any prospective investment recommendations, which includes any fund in which Aurum is already invested. We can, and do, exercise this veto citing “poor culture”, because it may well be that a structural weakness, major control failing or other risk event has been wholly or in part caused by the type of working environment fostered by a manager.

The culture engendered by a manager is a key bellwether as to how investors can expect capital to be safeguarded. It can be the underlying cause of major operational risk events, therefore we encourage investors to take this into consideration when considering potential investments.