The headlines couldn’t have been better timed. .In January representatives of Bank of New York Co. were meeting with institutional investors in Asia to discuss the risk management tools the bank is now offering in conjunction with strategic partner Wilshire Associates, a Santa Monica, Californiabased consulting and analytics firm. Just as BoNY was making the argument that institutions need tools to manage a variety of risks, including events that can damage a company’s reputation, the Tokyo Stock Exchange started an investigation of Japanese Internet concern Livedoor Co. on the heels of the arrest of the company’s president for allegedly violating securities laws.
High-profile corporate flameouts like Livedoor’s aren’t the only reason institutions in Asia and around the world are turning to custodians for risk management assistance. In a 2005 survey of 76 large pension funds and nonprofit organizations around the world, BoNY found that although market risk remained a chief concern, about 80 percent planned to spend more time over the next five years trying to grasp and tame the operational risks faced by companies in their portfolios.
Brown Brothers Harriman & Co. also provides risk management services and tools, as does Mellon Analytical Solutions, a former Mellon Financial Corp. joint venture with Russell Investment Group that Mellon acquired in September. In January, State Street Corp. began offering online risk management, decision-making and investment-monitoring tools in partnership with Algorithmics, a Toronto-based unit of the Fitch Group.
“The big push in risk management for the buy side is one of this year’s top-ten trends,” says Andrew Liegel, a senior research analyst at Financial Insights, a Framingham, Massachusettsbased consulting firm that focuses on strategies for financial services businesses. Liegel says institutional investor demand is being driven by new regulatory requirements, the increased popularity of alternative investments and growing sophistication about risk. Developing or acquiring the tools and expertise to assess risk in-house is often too expensive and time-consuming for all but the biggest institutions. As a result, firms that specialize in risk management analysis -- having mined the investment banking market -- are now finding growth opportunities among institutional investors. Penetrating the buy side by partnering with custodians, which have existing institutional relationships, makes sense.
Debra Baker, BoNY’s head of global risk services, says the bank entered into an alliance with Wilshire because of the latter’s “very sophisticated models and analytical tools.” The alliance, she says, enables BoNY to provide this expertise to clients too small to perform risk management analytics in-house. “All over the world, clients are interested in better, faster and more-efficient ways to measure, manage and control their risks,” Baker says.
But risk management tools are not inexpensive. “The data feeds, hardware, software and support needed to do basic risk analysis on increasingly complex portfolios, particularly in fixed-income securities, are becoming unaffordable for many organizations,” says Karyn Williams, who coordinates new analytical products at Wilshire. She notes that receiving these services from a custodian is practical because “the custodian has the holdings, the accounting information, access to market data and even information on alternative assets. Pension funds have been asking us if there was a way to get their entire portfolio modeled in a way they could afford. This is it.”
Wilshire, for example, can examine the risk of a fixed-income portfolio across the Treasury, high-grade, high-yield and mortgage-backed markets. It also can look at portfolios containing all asset classes across multiple managers. At one large pension fund with about 100 managers, Wilshire found little performance difference between active managers and their benchmarks, leading the fund to consider indexing. Risk examinations also tend to discover previously unrecognized style drift: One fund learned that it was exposed to 25 percent more risk than it wanted.
Andrew Aziz, who heads market risk and buy-side solutions at Algorithmics, says that the same performance measurement and risk management tools that his firm has provided to banks for many years are now available on State Street’s portal, my.statestreet.com. Web access makes the tools easier to use, he notes. Several State Street clients are now testing a final version of the product; the custodian plans a full launch later this year.
“I see a higher degree of uncertainty among our institutional clients as a result of the new kind of investment instruments that are available,” says Thomas Klepsch, a State Street product and technology specialist in Germany. He attributes institutions’ increased interest in risk management tools to corporate treasurers who want to understand the risks that their pension fund managers are taking, to determine whether pensions are adequately funded under a variety of scenarios.
“Investment managers and pension funds are now doing what investment banks did a decade ago -- creating enterprise-risk oversight groups to replace desk-level risk management,” Algorithmics’ Aziz says. The next step is likely to be real-time risk management analysis, says Taylor Bodman, a partner at Brown Brothers Harriman. He believes that custodians are well positioned to provide that service too, giving investment managers the information they need to make better trades.
“BBH is already helping clients as an information services provider by integrating data with risk management systems in ways that are not possible to do manually,” Bodman says. “But the best pension funds won’t stop at being able to analyze risk by looking at historical data. Because of the velocity of trading, the volatility in the market and the availability of more and more investment opportunities that reprice in small increments 24-7, they are going to require a real-time risk management perspective.”
At Wilshire, Williams doesn’t see demand for real-time risk analytics among institutional investors just yet. “Many clients run the analytics daily to track their exposure and any deviation from stated benchmarks or from policy guidelines that impose very tight control over the investment process,” she says. “Others want to look at risk on a quarterly basis because their time frame is longer.”
Mark Patrick, director of finance at the Alexandria, Virginiabased Sheet Metal Workers’ National Pension Fund, oversees more than $2.8 billion in assets for 73,000 participants. After using the BoNY service for about a year, he says, the fund has recouped its expense through lower fiduciary insurance premiums.
“The insurer was very impressed by how we are able to monitor our 22 money managers,” Patrick says. “We get daily reports that tell us whether any of the managers have strayed from our investment guidelines, allowing us to make intelligent decisions. Before we used the service, we’d go through the portfolios at a fixed point at the end of the month. I always felt we could have been missing something.”
Peter Hadasch, who oversees the E781 million ($932.1 million) pension fund of Nestlé’s German subsidiary, says that the technology provided by State Street and Algorithmics “is a welcome addition, allowing us to access our investment information in multiple views and forecast outcomes for varying levels of risk.”
Erwin Martens, executive vice president for risk management at TIAA-CREF, believes that institutional size determines how risk management is best performed. “For smaller funds, custodians are a natural choice,” he says, adding that for institutions with less than $5 billion in assets, in-house risk management “makes no sense.” But as more institutions invest in a wider variety of alternative investments, Martens says, risk management will become more difficult.
“A commitment to alternatives is not trivial,” he says. “Integrating those investments into a broad risk management process is pretty challenging.”
