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Protecting Against
Alternative
Investment Risk
How to Manage the Risks Associated with
Non-Traditional Investments
by Matthew Botein
A
properly designed and managed
set of alternative investments
can play an important role in
enhancing institutional investor
portfolios. However, many
institutional investors have concerns
over the inclusion of alternative
investments in their strategy.
Comprehensive and thorough risk
management is key to allaying these
concerns – but it is something that
must be deeply embedded within the
entire investment process rather
than implemented as an overlay after
the fact.
In general terms, alternative
investments include all investment
strategies outside of long-only
equity, fixed income and cash
instruments. Four of the broadest
alternative asset strategies for
institutional investors are hedge
funds, private equity, real estate and
commodities. These can offer two
distinct benefits to an institutional
portfolio: diversification through
exposure to non-traditional beta or
risk premia that are unavailable via
traditional products; and alpha, or
excess returns from manager skill.
During the recent global financial
crisis, diversification offered limited
protection as correlations between
many ordinarily unrelated asset
classes increased sharply.
Furthermore, a lack of in-depth risk
management meant that many
investors did not fully understand
the underlying return drivers of
alternative asset classes and their
changing patterns over the
economic cycle.
Comprehensive risk
management is essential
to alternative investing –
but it must be embedded
within the entire process,
not added as an overlay.
Since the crisis, the regulatory
environment in which alternatives
managers operate has changed
considerably. For example, the
enactment of the Dodd-Frank Wall
Street Reform and Consumer
Protection Act in the US is expected
to limit the proprietary investing
activities and sponsorship of
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January 2011 issue
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alternative asset providers managed
by banks and certain other regulated
financial institutions. In Europe, the
Alternative Investment Fund
Managers (AIFM) Directive will
impose registration, reporting and
initial capital requirements on
alternatives managers.
However, these developments – and
the market stresses that preceded
them – have not diminished the case
Matthew Botein is head of
BlackRock Alternative Investors,
the firm’s dedicated alternative
investment platform. Below, he
shares his views on the impact of
regulatory reform on alternatives,
how the ‘barbell’ investment trend
will affect the industry and why
BlackRock is different from
its competitors.
How has Financial Regulation
Impacted Alternatives?
Regulatory reform – specifically
the recently enacted Dodd-Frank
Wall Street Reform and Consumer
Protection Act – puts significant
limitations on the proprietary
investing activities and
sponsorship of private equity and
hedge funds managed by banks
and certain other regulated
financial institutions. Beyond the
letter of this law, large financial
institutions appear to be focused
on de-risking and shedding
activities that look like proprietary
trading and investing. Increased
regulation and changes in investor
demands following the financial
crisis have also raised the barriers
for entering (or staying) for many
historically less-regulated firms
like hedge funds.
BlackRock’s longstanding position
in the market as an independent
asset manager, whose entire
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business model is based on
delivering returns to our investors,
positions us very favourably as the
world adjusts to these changes. We
are seeing talented teams from bank
proprietary trading desks and
boutique hedge funds that want to
align themselves with a platform that
gives them access to corporate
contacts, information flow, and
industry-leading risk management
capabilities and client relationships,
and yet allows them to be responsive
to the changes that investors and
regulators have dictated must take
place in the investment world.
What will the Current ‘Barbell’
Investing Trend Mean for
Alternatives?
I think it’s a very exciting thing for
alternatives. Barbelling may not be
the right option for every investor,
but many are taking the view that
they want to separate beta from
alpha and they want to purchase
optimal beta from efficient providers
for alternatives. Rather, they have
highlighted the need for more
dynamic and comprehensive risk
management processes that truly
reflect these underlying drivers and
the shifting world they inhabit.
who can produce at competitive
costs and with minimal error. I think
BlackRock is one of the bestpositioned providers of such beta.
Our opportunity now is to similarly
show that we’re also among the
pre-eminent manufacturers of
alpha streams, that we do so across
$100 billion of assets and that we
are able to identify exceptional
managers and exceptional
manufacturers of that alpha.
How do you Differentiate
Blackrock’s Capabilities from that
of Other Competitors?
I think there are at least two
differentiating characteristics.
First, we have no conflicts between
our proprietary trades and those of
our clients – every dollar we invest
is client money. We co-invest
alongside clients but we do not
have a single strategy where there’s
BlackRock house money invested
without our clients’ money. Second,
we bring a level of intellectual
capital, relationships and market
prominence that arms our
investment professionals with
more information – and more
specific investment opportunities
– than they could have as a
boutique investment manager.
There are many examples I have
seen of opportunities that reach
our fund managers that they simply
wouldn’t have access to elsewhere.
The Four Main Types of Risk
There are four broad categories of
risk facing investors in alternative
assets: investment risk liquidity risk,
operational risk and
organisational risk.
1) Investment Risk
Investment risk can be further
sub-divided into three broad
categories: primary risk, secondary
risk and idiosyncratic risk. Primary
risks include movements in interest
rates, equity markets, foreign
currencies and commodity prices.
Secondary risks are more nuanced
as they result from exposures that a
portfolio may exhibit to subsegments of a particular asset class.
For hedge funds, these risks may
emerge from exposure to equity
market volatility or credit spreads.
Secondary risks relevant to private
equity include exposures to a
particular industry or vintage year,
whereas real estate may include
geography as well as economic and
demographic trends. Idiosyncratic
risks are specific to certain
investments, such as the approval of
a merger or acquisition or change in
company management, which may
be unrelated to primary or
secondary risks.
It is essential that alternatives
managers have the necessary
experience and skills to avoid
unintended investment risks.
Investors should use managers that
demonstrate that portfolio
exposures are deliberate, diversified
and appropriately scaled.
2) Liquidity Risk
Liquidity risk occurs when an
investor is unable to meet its
liabilities due to a lack of
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immediately available funds in its
asset portfolio or when the selling of
liquid assets results in a portfolio
that is misaligned with its strategic
target. During the credit crisis,
liquidity risk became virtually a
household term, particularly in
relation to alternative assets.
Risk management for alternative
investments affected by liquidity risk
should include initial due diligence
and monitoring to ensure that a fund
has the appropriate liquidity for the
investment strategy employed and
the manager has a history of
adhering to withdrawal requests. It
should also include consideration of
sources of contingent liquidity risk,
such as the nature of one’s coinvestors in a given fund, which may
affect the demands on a fund’s
resources. Structural changes in the
availability of leverage for hedge
funds should also lead investors to
choose managers with access to
sufficient liquidity and the capability
to cope with a fall in liquidity.
3) Operational Risk
Operational risk is the risk of loss
resulting from inadequate controls,
people or systems, or from external
events. The shocking scope and
scale of Bernard L Madoff’s fraud
raised serious questions about the
ability of regulators to limit
operational risk and sharpened
investors’ focus on the paramount
importance of operational due
diligence. A proper assessment of
the operational risks at Madoff’s
organisation would have highlighted
issues such as the lack of a credible
auditor, irregularities in his business
model and an unknown (or
implausible) investment strategy.
The financial crisis pushed
counterparty and
collateral risks up the
agenda as previously
impregnable financial
institutions suddenly
looked vulnerable.
A vital aspect of operational risk is the
soundness of the operating and
internal control environments.
Standard practices such as the
segregation of duties, requiring two
signatures on key documents,
reconciling key financial balances and
statements, and the use of
independent auditors, custodians and
administrators, are all part of this.
The financial crisis also pushed
counterparty and collateral risks up
the agenda for investors, particularly
within the hedge fund space, as
previously impregnable financial
institutions suddenly looked
vulnerable. Investors should identify
hedge fund managers that are able
to negotiate competitive terms of
trade with counterparties and are
able to maintain strategic
relationships with them in times of
market stress. Any potential overreliance on a single broker should be
identified, as should excessive levels
of leverage and associated
counterparty risk. In addition, the
reduced availability and higher cost
of financing in recent years has made
it increasingly important to monitor
the impact financing can have on
fund returns.
When investing directly with a quality
institutional fund manager, robust
internal controls and procedures
tend to mitigate operational risks.
Nevertheless, investors should still
conduct appropriate levels of due
diligence across the key areas
outlined above.
4) Organisational Risk
Organisational risk relates to the
ability of an organisation to
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withstand a significant economic or
market downturn. The financial crisis
demonstrated the importance of
partnering with a large institutional
alternative solutions provider that
can cope effectively with periods of
major market disruption. In-depth
due diligence and scenario-testing
can help investors assess the
robustness of an organisation during
such periods.
To maximise the potential
of an alternatives portfolio,
investors need a partner
with solid risk
management, strong
compliance procedures,
transparency and
expertise in numerous
asset classes.
Seeking Best Practice
When determining whether a
potential partner undertakes best
practice in risk management,
investors can use a number of
criteria. For example, the
institutional partner should never
trade against or ahead of its clients.
It is also vital that the platform has a
strong team of talented, experienced
individuals with a deep knowledge of
alternative investments, a strong
risk management culture (which
operates independently of the
investment team) and sophisticated
systems to analyse and manage
investment risks on a continuous
and dynamic basis.
In order to control factors such as
counterparty risk, investors should
seek an investment partner that is
able to demonstrate strong
experience in handling counterparty
risk through negotiation,
management and diversification. In
the same way, the partner should
manage liquidity risk by ensuring
that the underlying investment
strategies have suitable liquidity and
any restrictions, such as gates and
side pockets, are used appropriately.
Furthermore, the ideal alternatives
platform should feature an
alignment of interests between the
investors and the partner. There
should also be sufficient
transparency to ensure that
investors can understand the risks
relevant to their investment.
Above all, investors need to seek a
partner who can provide them with
the assurance of an alternatives
allocation where positions are
deliberate, diversified and
appropriately scaled in order to
increase the long-term risk-adjusted
return potential of their portfolio.
The Multi-Asset Class
Opportunity Set in Alternatives
For those investors who are able to
identify partners with these
attributes, the new financial
landscape looks favourable for many
alternative assets.
In hedge funds, the uncertain
economic and market environment is
creating some compelling
opportunities for managers with the
requisite skill and insight at a time
when proprietary trading desks have
been decapitalised as competitors.
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In private equity, corporate spin-offs
and deleveraging are increasing,
while the changing regulatory
environment with respect to
healthcare, financials and energy
also presents attractive investment
potential. Opportunities in real
estate are appealing in the current
low-yielding environment, while
commodities remain useful as an
inflation hedge.
These factors add up to a strong
case for long-term investors having
an appropriate allocation to
alternative assets. However, in order
to maximise the potential of a
strategic allocation to alternatives,
it is vital that investors seek a
partner with a focus on risk
management, strong compliance
procedures, transparency and
expertise in a wide range of asset
classes – in other words, a partner
that can be trusted to identify the
right solutions for a client and
manage them appropriately within a
diversified portfolio. t
Currents
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