Adapting buy-side risk management strategies for complex market dynamics

Luke Armstrong from S&P Global Market Intelligence, Thomas Sheedy from Invesco and Julien Cuisinier from Artemis Fund Management explore the challenges and adaptive strategies shaping the evolving field of buy-side risk management

In the face of heightened volatility and rising interest rates, buy-side risk managers are navigating complex market dynamics, grappling with liquidity challenges and incorporating climate risk considerations. As technology continues to evolve, firms are leveraging advanced data analytics and technology capabilities to enhance risk assessment and decision-making processes, striving for efficiency and accuracy amid increasing complexity.
 

What are the primary concerns in buy-side risk management and what challenges are firms facing when addressing them?

Thomas Sheedy: The primary concern is ensuring consistent performance amid new challenges. This includes navigating risks such as higher interest rates, persistent inflation, recession fears and unpredictable market shocks related to geopolitical events. The dynamic nature of investment themes and asset classes adds to the complexity.

With a shift to higher interest rates, there’s a need to reassess risk payoffs. The return to a more normal environment raises questions about the impact on credit risk – especially when projects were initiated with a lower cost of capital. Real assets, real estate and loans – particularly in refinancing scenarios – face challenges, which are exemplified by issues in the Chinese real estate market.

There is also concern regarding the timing of market moves. Balancing short-term opportunities with long-term goals requires flexibility and nimbleness in investment strategies. It’s crucial to avoid being overly bearish too soon and missing potential upside. The challenge lies in acknowledging market timing aspects without compromising long-term objectives.
 

What are the implications for liquidity and market risk of the rapid transition to a high-rate environment?

Julien Cuisinier: Risk teams, accustomed to volatility in equities, are now dealing with a substantial increase in fixed income volatility. The challenge is that managing a similar exposure in duration and credit spreads will generate more pronounced volatility in returns than in the past.

The traditional balancing impact of fixed income in multi-asset portfolios has diminished. Multi-asset returns are more influenced by fixed income than equities, marking a shift in the expected diversification and balance provided by fixed income.

Risk teams face challenges in understanding and managing liquidity – particularly in fixed income. Historical approaches, based on assumed volumes tied to currency, credit rating and other factors, are proving insufficient. Fixed income liquidity is more unpredictable and can vanish quickly, with risk management frameworks ill-equipped to handle sudden one-sided markets.

There is a misconception around transaction costs in fixed income. Many assume minimal impact but, in reality, market price impact and transaction costs in fixed income can be higher than in equities, especially with increasing volatility. The inadequacy of current risk frameworks in dealing with these higher transaction costs poses an additional challenge.

Luke Armstrong: The shift from a low-volatility environment with low global interest rates to higher rates has escalated quickly. This leads to heightened volatility – particularly in the bond market, as new bonds are issued at higher yields. The resulting strain on liquidity occurs as portfolios are impacted by marked-down values of bonds issued at lower rates, prompting demand for portfolio changes and increased selling pressure.

This rate hike effect creates a circular challenge for issuers. While investors seek higher-rate bonds, issuers struggle to issue new bonds at elevated rates because of increased costs. This creates a complex cycle where inflation raises business costs, the value of assets and debt decreases, and issuing new debt becomes more difficult.

The current scenario marks a departure from the benign, low-volatility environment of the past decade. The dynamics of rising rates and inflation – and their impact on market behaviour and liquidity – present challenges not experienced in the previous 10–15 years.
 

How are firms adapting in this high-rate environment?

Thomas Sheedy: In managing market risk amid a higher-rate environment, our focus is on distinguishing between portfolio- and market-driven actions. Invesco dedicates significant effort to understanding the increased volatility in the interest rate environment and its impact on market dynamics. There’s a recognition that relying solely on models for market risk prediction is risky, given the frequent correlation breaks observed over the past two decades. We approach tracking errors cautiously, considering the environment, stressors and potential rapid shifts in market conditions. Understanding how the market can swiftly influence risk profiles is crucial, given the unpredictability and speed with which risks can change in today’s dynamic environment.

Julien Cuisinier: In a high-rate environment, the risk of tail events is higher, necessitating a revaluation of market risk analysis. The focus is on understanding how quickly adverse events can occur with increased interest rates.

Cloud-native solutions have become the standard, offering scalability and performance

Luke Armstrong, S&P Global Market Intelligence

Risk teams are examining the impact of higher rates on the profitability of businesses – particularly those heavily indebted. Questions are being raised about financing structures, refinancing capabilities and the ability to pass on increased costs to customers.

They are using differentiated approaches based on asset types. While liquid assets with low turnover strategies may see fewer changes, illiquid assets – such as private equity and infrastructure – face concerns about unrecognised valuation compression due to rate changes. For illiquid assets, there’s a focus on when the market will recognise value compression in the face of rate changes. The lack of frequent valuation cycles may delay the realisation of this impact.

Tailoring risk management processes depends on a fund’s composition. While there may be minimal changes for portfolios with low turnover, high-frequency trading or multistrike hedge funds may require a more real-time risk assessment rather than relying on end-of-day positions.

Luke Armstrong: Risk teams are more integrated into front-office processes, actively challenging and providing different perspectives on risks associated with higher rates, increased volatility and inflation. This ensures all inherent risks in portfolios are identified and communicated to the front office for awareness.

There’s a shift towards a holistic risk management approach that includes market risk, liquidity risk and – to some extent – climate risk. This broader perspective obtains a comprehensive view of risks rather than focusing solely on market risk.

Clients are expressing a heightened need for liquidity, and engagement around liquidity has increased significantly. Accurately modelling liquidity in the current challenging environment is a key concern. The emphasis is on incorporating liquidity considerations into the risk management process.

While there’s a change in approach because of the higher-rate environment and increased volatility, the measures used for market risk remain similar. The key shift is towards greater integration with the front office, ensuring a cohesive risk management process.
 

To what extent are firms addressing the interaction of market, liquidity and climate risk?

Thomas Sheedy: Bringing market, liquidity and climate risk together involves a shift from isolated exercises to a more integrated approach. The challenge is proving the value of data sources and understanding their contribution to decision-making. Cross-pollinating climate and environmental, social and governance (ESG) data with other risk information is an ongoing journey, and the industry is still in the early stages of demonstrating tangible value outcomes.

The discussion around market liquidity is crucial because of regulatory considerations. While modelling is precise, its accuracy is debatable, especially given its reliance on historical data. The dynamic nature of market shifts requires a holistic approach to incorporating additional information. In summary, integrating market liquidity and climate risk involves navigating complexities – and there’s no easy answer at this stage.

Julien Cuisinier: Artemis Fund Management is grappling with the interaction of market, liquidity and climate risk. Using a risk dashboard, we identify stocks that flag on all three fronts and challenge them in regular meetings with fund managers. The link between liquidity and market risk is more evident in illiquid asset portfolios, where smaller market cap and lower liquidity combine as risks. While the connection with ESG risk may be less obvious, instances where a stock flagging on all three fronts prompts scrutiny and challenges.

The role of a dedicated team is crucial in consolidating and summarising data into actionable insights. Visualisation tools can be used at the portfolio level to identify the highest risks in market risk, liquidity and ESG. At the firm level, committees and reporting systems can be implemented to flag stocks with significant risks in all three categories. This ensures executives have accessible reports outlining the potential impact on funds because of identified risks. Ultimately, asset managers would need to adapt a chief information officer dashboard approach.

Luke Armstrong: Diversifying the focus of risk teams beyond market risk necessitates an integrated approach where risk management covers all risk factors collaboratively. A current focus for us is to add liquidity and climate risk factors into risk management processes to diversify the perspective beyond traditional market risk analysis. This could involve identifying positions that have significant climate or liquidity risk but wouldn’t ordinarily be highlighted by market risk measures, such as value-at-risk or tracking error.

To achieve a concise view of the portfolio across market, liquidity and climate risks, asset managers should invest in a comprehensive technology solution.

Many currently use multiple tools for different asset classes and risk factors, making it challenging to consolidate insights. A unified technology solution enables risk managers to seamlessly integrate various risk types into a single report, analysis or front-office challenge.

While some risk managers have sophisticated systems, they often resort to spreadsheets to fill gaps in software solutions. This manual approach poses operational risks and consumes valuable time. A sophisticated, scalable technology solution covering all risk types is essential for efficiency, accuracy and completeness in risk management processes. This ensures more time is spent adding value to risk management and front-office processes rather than on manual data collation.
 

What sort of data analytics and technology capabilities are firms using to keep up with all of this?

Julien Cuisinier: Artemis is not currently investing in external data analytics and technology capabilities. Our primary concern – especially in terms of liquidity – is a lack of market pricing. We have developed a target platform and are expanding to include third-party data. We utilise an analytics platform and are exploring additional network providers. However, the high cost of solutions and the rapidly changing regulatory landscape make external options expensive. We focus on internal data and have not found an external model that meets all of our reporting requirements.

Luke Armstrong: Asset managers are focused on leveraging extensive data – particularly intraday data – to reprice portfolios dynamically. Cloud-native solutions have become the standard, offering scalability and performance. Intraday repricing is facilitated by cloud-native technology, enabling quick and efficient calculations. This approach ensures systems are always ready and adequately sized to handle portfolios and instrument types. Embracing modern technology is essential, as outdated tech stacks cannot keep up with evolving requirements, leading to increased reliance on Excel spreadsheets.

Thomas Sheedy: In the next year or two, Invesco will be engaged in a comprehensive tech infrastructure project to streamline and simplify its systems. The goal is to consolidate data sources, making methodologies more comparable across asset classes for improved cost/benefit analysis. While the historical approach of using the best-of-breed for each asset class still exists, there’s a growing need for compromise due to the cost of acquiring every available model. The focus is on condensing various data sources into manageable, market-standard chunks. In the realm of risk management, selectivity is becoming crucial, striking a balance between wanting comprehensive data and managing costs effectively.

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