Dark memories: Coronavirus and the spectral return of exposure management

By Russ Bryan | 8 June 2020

As with the 2008 market crash, the coronavirus has brought the issue of exposure management to prominence once again. Recent market volatility has sent shockwaves through the financial community and resurfaced some dark memories that most of us would prefer to forget.

When the markets are fluctuating at an alarming rate, asset owners in particular will feel vulnerable. Post-Lehman Brothers, it became apparent how few life and pension owners really understood their aggregate exposures. Asset owners (especially those with complex fund structures) realised that they needed the ‘big picture’ in order to improve their investment decision-making, mitigate their risk and reduce their response time to external market conditions. Technology was positioned by some vendors as the global panacea.

Unfortunately, many asset owners have been underserved by technology for a long time. Nevertheless, as they have grown in assets under management, their spend on technology has increased. Many are gradually moving away from outsourcing everything in their back offices to their custodians to a more self-sufficient model.

This is very different from the world of the buy-side investment manager, an area that has, if anything, been over-serviced by technology for the last few decades. There are a plethora of portfolio management, trading and compliance systems that serve asset managers very well.

With the large life insurance or pensions businesses, however, technological requirements are far more complex. In order to achieve the diversification that they desire, these firms may engage 50, 60 or even more asset managers covering passive investments, specialist global equity managers, emerging market managers, bond managers and so on.

These asset managers work in isolation from each other, building their portfolios according to the mandates set for them by the asset owner. They have no knowledge of the other investment objectives set by the asset owner and therefore have no context for their actions.

The challenge for the asset owner is to determine, by aggregate, what kind of exposures it has across all of its asset managers and in operational terms, how it should manage this immense fund structure. There are difficulties associated with understanding the risk, but there are also day-to-day challenges associated with rebalancing the funds to ensure that they stay in line with the various asset allocation targets that have been agreed.

A key task for these large asset owners is therefore one of oversight; they must manage asset allocation and risk at a macro level. Whilst not concerned with the buying and selling of individual securities, they are concerned with aggregated exposures across different asset classes in different geographic regions. They often build their businesses using fairly complex fund structures of unitised collective investments.

The complexity of one fund investing in another fund, in turn investing in another fund, results in fund structures that rapidly become many levels deep. It is therefore difficult to analyse where money has been invested and the underlying exposures that exist.

Asset owners typically need to deal with such large fund of fund structures, simplify them and transform the data in such a way that it is as easy to handle as the ‘flat’ portfolios of assets that asset managers understand and deal with every day.

The key issue is that of ‘look through’ – penetrating through the layers of unitisation. Many systems claim to provide ‘look through’ but, in reality, this is available only to a limited extent, as the main focus of EDM applications is generally elsewhere.

Asset owners must understand and unravel the complexities that have grown over time within their own business and create an awareness of the risks associated with their current state. In this way, asset owners can become more nimble, able to respond faster to external events, such as the coronavirus, and deliver the asset owner’s aggregate exposure immediately.

Central to this objective is improving the flow of this type of information through the organisation. Often this data resides in various pools across the organisation, but usually it is locked away in functional silos or applications. It is therefore hard to access this data and use it for anything meaningful. Taking aggregated risk data out of functional silos and making it available across an entire firm gives context to decision-making for a wider group of professionals.

Asset owners also struggle with another operational problem. If one considers the task of asset allocation, it’s clearly of benefit having a database platform that allows a firm to analyse the exposures and perform the necessary reporting. What most asset owners really need, however, is a tool that allows them to monitor their exposures on a daily basis and to compare them with pre-determined targets, in order to rebalance the various high-level holdings e.g. transferring cash from one account to another.

The portfolio modelling vendors in the market are very effective at this when dealing with equities that are traded on a stock exchange, bonds that are traded with a bank, or FX OTCs that are traded with a counterparty, but they cannot do so as effectively when dealing with units of an underlying fund within fund of fund structures.

Not so long ago the great fear was exposure to Greek and Italian banks. During the sovereign debt crisis of 2010 both countries teetered on the edge of financial collapse, but recently both countries had been making substantial progress in steadying their respective ships. Greek banks had been preparing to sell billions of euros of bad debt to free up their balance sheets while Italian banks had been trading their most risk-laden bonds at record-low yields. Now the patchwork recovery of Italian and Greek banks (and the European Union’s two most heavily indebted countries as a whole) lies in tatters as the global impacts of coronavirus send thoroughbred economies reeling.

The experience has demonstrated that we are never far from the next crisis and, sometimes, still not free from the last one

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