AIFMD and the Evolution of Risk Management

Risk management in the alternative investment industry is changing. Recent legislation – in particular, the EU’s AIFMD – has transformed the role and purpose of the function.

Risk management has traditionally concerned itself purely with portfolio decisions. But under AIFMD, it has become a more holistic role, embracing all dimensions of the investment value chain: portfolio, operational and liquidity risks, as well as risks delegated to third parties.

A new reality

As a result, risk managers have become increasingly reliant on systems, processes, and procedures, and on more personnel, to remain compliant. At the same time, they are having to take on a far more detailed understanding of the risks affecting the third parties their firms work with. This includes brokers, custodians, administrators, and any other organizations that support their operations.

What’s more, AIFMD has changed the very purpose of risk management in alternative funds. In the past, trading positions were taken, then evaluated for their potential risks. But under the new rules, risk management must be embedded in the decision making processes that happen before investments are made.

Some larger funds have long had these sorts of arrangements in place. But under AIFMD, all alternative fund managers must systematically take a ‘pre-trade’ approach to risk management. As a result, we’re seeing much greater collaboration between the risk and portfolio management functions within hedge funds, on critical tasks such as risk attribution and margin-at-risk impact.

Model limitations

A good example of pre-trade risk management in action is among systematic commodity trading advisers (CTAs). CTAs use sophisticated algorithms to detect market signals and make their investments. As such, there’s little involvement from risk teams in the ‘live’ decision-making process.

Risk managers are deeply involved in the validation of the risk models on which trading algorithms are based, which means greater caution being applied when testing the resilience of trading models.

Of course, caution is not a bad thing when it comes to risk management. But no amount of caution can help risk models to predict future volatility.

It’s therefore essential to be aware of the limitations of risk models. As well as considering what the models say, it’s important to be attuned to the qualitative risks at hand. Rather than being seen as decision-making tools, models like the Black-Scholes formula for pricing commodity options should be used merely as starting points.

Paradigm shift

The truth is that AIFMD represents a new paradigm for risk management in alternative investment funds. Adapting to the new rules will demand a change of philosophy, culture and mindset among risk managers.

We’re already seeing this evolution begin to happen among the industry. Risk managers are increasingly conscious of the limitations of risk models, and are less inclined to see them as an accurate picture of reality. As a result, they’re applying more rigorous governance to the models they use.

With a greater focus on risk, and heightened awareness of the limitations of risk models, the alternative investment industry is working harder than ever to ensure they operate safely in today’s financial markets.

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