There was a time when simply saying you had a risk system (preferably one that was well known, such as RiskMetrics) was enough to satisfy investors. Those were the good old days.
As risk managers became more experienced, the quality of risk reporting improved along with the types of questions asked by more experienced investors and portfolio managers who began using risk reporting. Often these focus on recent headline news and how that might impact the portfolio (China stress scenario of 2015 comes to mind), or what scenarios will help or hurt the portfolio most. It may even delve into a more nuanced explanation of how the portfolio is hedged against certain types of events and what exposures have changed over time.
Are you prepared to answer these types of questions without being caught off-guard?
For most risk managers this is comfortable territory and is an opportunity to shine and demonstrate your understanding of how your firm’s portfolio strategy is reflected in the risk reporting. Risk managers are usually prepared to answer these questions and welcome this line of questioning from the internal risk committee, portfolio managers, their CIO and outside investors. I call these the “what” questions.
What happens to your portfolio if x, y or z occurs? What is the best scenario and worst scenarios for the portfolio? What is the current exposure now and what has it been in the past? What hedging strategy is reflected in the risk reports?
However, risk questions can get a lot harder to answer, particularly in the regulated markets (think banking stress tests and model validation exercises that take months, if not years to perform), as they turn to the how and why.
How are risk models selected, configured, validated and monitored? Why do some perform as expected and others don’t?
…Risk managers who are slow to adopt these practices may feel like they are suddenly in the cross-hairs of the Mueller investigation…
Although this practice started in the banking sector, just like risk reporting started with the 4:15 report at JPM, it is slowly working its way into the hedge fund, asset manager and asset allocator space as these practices are adopted by experienced risk managers. Like all changes, some are adopted more slowly than others and this is no different. Risk managers who are slow to adopt these practices may feel like they are suddenly in the cross-hairs of the Mueller investigation when confronted by this line of questioning: worried that failing to answer a question adequately may indict their entire risk process or worse.
With that, I give you the 10 most painful questions for a risk manager:
- What versions of risk models are used in the risk reports?
- What risk model is used for each security type in the portfolio?
- What custom model configurations are being used?
- How many positions are not being modeled or modeled to a proxy?
- What are the proxy rules being used and how many securities does this impact?
- How do you know all positions are being properly modeled?
- What position types fail most often and why?
- When was the last time you updated risk models or checked for new versions?
- What models fail backtests? Do they underestimate or overestimate risk?
- How do you identify and explain significant changes in risk reports?
Are you prepared to answer these types of questions without being caught off-guard?
If you are not sure, an independent risk audit may help you identify any weaknesses in your risk process, how to remediate any deficiencies, and recommend areas where you can benefit from improvements. You can start with Red Swan’s promotional risk audit service, it’s free for the first 6 months.