Risk management key to surviving downturn: Report

Managing risk is essential to the survival of asset management firms, according to a new report by Ernst & Young. The report points out the specific risks asset managers must recognize and overcome to position themselves for long-term success.

The report says the current market crisis is by far the most immediate and dangerous threat that asset managers face. And a failure to adequately deal with the global financial crisis could result in the demise of the asset management business in general.

There appear to be two broad general areas asset managers need to address to survive. The first is preserving capital — containing costs through expense management — and downsizing employment where it’s deemed strategically necessary.

An even more fundamental task for asset managers, the report says, is the re-evaluation of risk management capabilities and controls. This means identifying and reducing risk not only within the portfolios they manage but also among other risk categories they might not have addressed before, says Michael Israels, Canadian leader of asset management advisory services at Ernst &Young.

The financial crisis has a bit of a silver lining in that it does provide a template from which firms can assess how things can go wrong in very adverse market conditions.

“Firms need to take a very structured and disciplined approach to the way they view risk,” Israels says. “There are quite a few lessons learned from the financial crisis itself. A lot of firms specific to risk management were guilty of taking a narrower view of risk. We would typically encourage firms to broaden their view of risk to include a more holistic view of risk, which includes business and strategic risk, compliance risk and operational risk.”

The crisis seems to have accentuated some trends already underway in the industry, such as the increased desire by boomer investors for income-generating investment products rather than accumulation products and an abandonment of long-only equity strategies.

The report argues that even beyond the crisis, the risk appetite for all investors will be substantially diminished. It also highlights that investor preference for low-cost passive investment strategies (i.e. ETFs) will likely continue to increase. This will create an increased burden on active managers to produce returns above their benchmark on a consistent basis.

Israels suggests that asset managers are going to have to work harder to understand what their core demographics of investors need. He still foresees advisors in the retail space, and consultants and plan administrators in the institutional space, remaining the important distribution networks.

He notes that asset managers are going to want to have greater contact with the end client so they can understand what exactly it is they should be strategically focusing on with the products and services they provide.

“I don’t see any significant change in the landscape per se. I think that asset managers, working with the distribution arms, need to get closer than they ever have to their client base. They really need to understand what is driving their needs and their risk appetite,” he says. “In some ways, there has been a bit of a wall between client investors and distribution firms. Asset managers in the retail context need to be able to gain that sort of intelligence from the investor marketplace. On the institutional side, traditionally, there has been some direct contact, but historically, that has been the role of pension and investment consultants.”

In this communication with the end investor, asset managers will need to be more proactive and transparent in their communication with end investors. According to the report, one of the other big threats that asset managers face is the increased scrutiny of regulators. To avoid being “over-regulated,” asset managers need to be more forthcoming with the info they provide clients.

“With the industry in the public spotlight, engaging in proactive communication will be key. To diminish the threat of an escalating and increasingly politicized reaction to the crisis, it is important that companies are ahead of issues rather than responding reactively to events,” the report says. “Companies need to be able to describe the products they offer and be in a position to clearly explain the risk profile.”

Selling risk management to clients will take on greater importance, Israels notes. It will not trump performance, but it will be a key area clients will want addressed before investing with a given firm. In particular, operational controls to minimize the effect of trading losses will be important.

Israels says day-to-day losses within trading positions of a firm will happen. Poor operational controls could fail to contain those losses, thereby affecting the entire firm. The crisis has highlighted that poor operational risk management and firm governance have created “catastrophic losses.”

“Investors themselves are going to drive enhanced risk management. They want to deal with firms that have proper governance and effective controls. They want to be dealing with firms that have appropriate transparency,” Israels says. “Day to day, asset managers make a bad decision; it generally won’t result in a catastrophic loss. If you have poor controls over business processes and the operations — the engine of an asset manager’s operation — that can lead to a catastrophic loss in a short period of time.”

(03/31/09)