Clients catch on to risk management

However, most private banks in Asia mainly operate on a very small fraction of an individual’s wealth, which is a major hurdle to the true implementation of a holistic risk management system. “The kind of risk management practices that may be used on a small sliver of a portfolio are very different to the strategies that can be applied to a total portfolio,” argues Peter Ryan-Kane, head of portfolio advisory Asia-Pacific at consultancy Towers Watson.

Private wealth clients seek out different providers for different skill sets, the banks often use different risk strategies and the parts of the client’s portfolio each of them manage are very different too. But risks, unlike returns, cannot be added to make up a total portfolio risk, says Mr Ryan-Kane. “The claims around holistic risk management in the private space are pretty overstated, whereas institutional investors and their stakeholders are better equipped to think about risk management across all dimensions of the portfolio.”

Although private banks claim to offer a risk monitoring service on their clients’ entire wealth, individuals are often reluctant to disclose their total portfolio to one provider. This is a deadlock situation for both clients and providers. “What banks can do is to improve risk management at lower levels, and many of them have certainly done so,” says Mr Ryan-Kane.

This means devising the right asset allocation to achieve clients’ objectives, monitoring incremental risk derived from adding new asset classes, improving due diligence on managers and down to the security level, both in terms of monitoring volatility and impact of potential default.

The selling process, normally skewed to relationship manager remuneration, is certainly another area that requires more work. “The remuneration process for relationship managers drives portfolio behaviour and recommendation behaviour more than it should,” he says. “Rather than denying it, private banks should recognise it and put in place processes and systems that put the client first.”

Moreover, the quantitative side should play a pretty small role in risk management, says Mr Ryan-Kane. “The reality is that most risks that occur in portfolios and in markets are just not captured by data. When things go wrong, the most frequent reaction is complete and utter inactivity, because they just don’t have a framework for dealing with emergencies. It’s like setting off onboard a submarine, without any clue as to what you are going to do if the thing springs a leak at a thousand feet underwater.”

Most of the effects of the crisis took a while to flow through markets. When Lehman failed, the market reached its lowest point only six weeks later, but most people did nothing in those six weeks. “People don’t think about contingency, and that’s because a lot of the process is too product focused,” says Mr Ryan-Kane.

BASIC LEVELS

A successful risk management strategy comes from finding a good balance between the quantitative and qualitative side, believes Didier Duret, global CIO, ABN Amro Private Banking. “The room for improvement is really at the relationship manager level. RMs should be more educated about the risk of each instrument and about the concept of diversification,” he says.

Today, relationship managers are able to talk about total risk, tracking error, contribution to risk and are aware of the risk tools available to them, all of which was unknown before the crisis, he says, explaining that the Dutch bank has been working with business school Insead to develop a customised risk management programme for advisers.

Pre-Lehman, risk specialists used to look at risk just from the pure quantitative perspective. Today they have broader skills, they are generally more hands-on and have often had client-facing experience. “Risk management people are generally more humble today. They would like to connect with the client and have a more personalised approach.

“The problem in risk management is to avoid the silo mentality, and Lehman was very interesting for that,” says Mr Duret. At ABN Amro, some divisions were negative on Lehman as a credit risk, but other divisions such as the one responsible for structured products or deposits had not assessed the counterparty risk. “What was missing was the bridge between the pure credit risk and the counterparty risk,” he admits.

The partnership agreement that ABN Amro Private Banking signed last year with Lyxor, the hedge fund subsidiary of Société Générale, responded to the need to provide a higher level of risk management and transparency in the alternative space, claims Mr Duret. The move was made mainly to meet demand for hedge funds, coming particularly from clients both in Asia and Switzerland, although the Dutch bank’s clients typically have had little exposure to hedge funds.

BASIC LEVELS

Despite ample recognition of their importance, risk control techniques employed by wealth managers remain at a pretty basic level. Findings from a recent study conducted by Edhec-Risk show private wealth managers in Europe see the relationships they forge with clients as the principal source of the value they add, while customised services, such as financial risk management, do not rank very high.

“The lack of sophistication in risk management techniques that we see in Europe is even more pronounced in Asia,” says Professor Stoyan Stoyanov, head of research for EDHEC-Risk Institute-Asia. Some relatively new concepts, such as asset liability management or life-cycle investing, are still largely unknown, although they are perceived to add most value to meet client objectives.

The dynamic asset liability management framework focuses on the importance of assigning different functions to the various building blocks that should constitute clients’ portfolios. The idea is that the investment decision can be separated into a performance-seeking portfolio, which maximises the Sharpe ratio, and one or more hedging portfolios. The optimal allocation between these must meet the clients’ risk budget constraints.

“The allocation between building blocks should not be fixed but should be dynamically adjusted depending on various factors, such as the size of the risk budget,” says Mr Stoyanov.

The risk budget can be defined in terms of maximum drawdown, which must be discussed by the wealth manager with the private client. In a market downturn, the value of the client’s portfolio starts decreasing and the risk budget will diminish. “The more the risk budget shrinks, the less money should be allocated to the part of the portfolio seeking performance, and the more money to the part of the portfolio that should hedge consumption objectives,” he says. But only a small minority of private wealth managers take into account these client-specific objectives, says the study.

However, after the financial crisis, people have started to appreciate the concept of asset allocation and the inherent risk of investing in asset classes such as equity, says Ashish Khetan, head family office and advisory services at Kotak Mahindra Bank in India. “After the financial crisis, people are far more conscious of risk. There has been far more appreciation of the necessary balancing act between greed and fear,” he says.

Kotak launched its advisory and family office practice three years ago and spends significant time and resources explaining to clients the importance of diversifying their portfolios, of following an asset allocation that is commensurate to their risk appetite and regularly reassessing their risk profile to rebalance portfolios.

However, says Mr Khetan, there is no doubt there is still a gap between Indian wealth management institutions and their counterparts in more mature markets like Europe. “The whole concept of a more disciplined approach to investing in a more formal manner has just started coming up in India. There is a gap in terms of the tools that are used to evaluate or mitigate risk and client understanding, and to an extent, whether the client really appreciates these kind of tools,” says Mr Khetan.

That depends on the client sophistication too. Those who have built their wealth on their own profession are more likely to follow Kotak Mahindra’s “safety pot theory”, which recommends that a part of the assets should be invested safely to take care of the individual’s lifestyle and consumption needs, while the rest of the portfolio can be earmarked for growth.

Clients tend to find concepts like efficient frontiers or standard deviations “far too scientific or far too clinical” and therefore it is important to temper this kind of talk with more familiar types of arguments such as the “safety pot theory”, explains Mr Khetan.

Concentration risk is still a major issue in India, partly because of constraints ($200,000 per individual per year) on overseas investments for Indian residents. Even so, most of the families do not pursue that diversification. They believe in India as a growth story and they want to invest where they are more familiar. The limit allowed for international investing is primarily allocated to property overseas.

Kotak therefore recommends portfolio diversification at an asset class level. For example, within equity there are certain sectors, such as the technology sector, which are not depending on the Indian growth story.

There are wealthy families willing to invest more globally in order to mitigate the volatility of the Indian equity market – the Indian equity benchmark, NSE, had an average annual volatility of 25 per cent over the past 25 years. “But there are a whole host of wealthy families that believe it is possible to be opportunistic and time your entry and exit into different asset classes. This is where we have the biggest challenge,” says Mr Khetan.

Risk management strategies should be tailored to the individual’s needs and involve complex research but simple solutions. This is the motto of Lok Yim, head of PWM North Asia at Deutsche Bank. Wealthy entrepreneurs, who constitute Deutsche’s target, are often owners of their own company. One of the greatest risks they run is that their wealth is concentrated in that single stock. The question is how to help them monetise or hedge some of that risk.

Today, inflation is one of the biggest concerns for many of them, particularly in China but also in Hong Kong, where property prices have gone up dramatically. In China, wealthy manufacturers have seen their margins squeezed by the increasing cost of wages, commodities and rent. Another risk the rich Chinese need to manage is that of currency. Although they believe in the long-term appreciation of the renminbi, they are concerned that all of their investments are in the same currency.

Risk management starts with asset allocation and that remains key, but with the ultra-wealthy type of clients who may have a very heavily concentrated portfolio in property, a 40 equity, 40 fixed income, 20 alternatives allocation does not work. In this case, it is important to assess the correlation of investments to property and diversify as much as possible.

“Asset allocation should be dynamic and you should shift asset allocation very quickly depending on risk and opportunities,” says Mr Yim. It is essential not to shy away from making big asset allocation calls, and reduce some asset classes to zero if there are perceived as having significant risks or increase remarkably exposure to others when opportunities arise.

“We do not recommend portfolio diversification just for the sake of it,” says Mr Yim.

On the other hand, although most of their wealth is still in Asia, rich clients are gradually more interested in exploring and learning about investment opportunities elsewhere. “It is going to take time, but I feel our clients are no longer Asian-centric.”

CATASTROPHIC EVENTS

“You can only mitigate risk. By having all the appropriate tools and using them in a disciplined way, you can reduce the risk, but you can never prepare for the black swan event such as market failure or an earthquake followed by a tsunami and nuclear fallout,” says Enrico Mattoli, managing director at UBS Wealth Management in Hong Kong.

Devising a diversified and optimised strategic asset allocation, consistent with the client’s objectives and risk profile, is the first major step to mitigating risk. Stress-testing each individual’s portfolio is very useful. The backward analysis shows the historical performance of the current portfolio and produces a number of parameters such as volatility and maximum drawdown in times of crisis, which help test the clients’ real risk appetite.

The ex-ante long run risk model looks at the future and enables to assign volatility and expected return to individual asset classes. The Montecarlo simulation is used to assign a probability distribution on the portfolio return and volatility associated with it, explains Mr Mattoli.

Managing shortfall risk, the risk that expected returns do not meet the individual’s investment goals is also key. The measure of the shortfall risk gives you an idea of when the investor will get back his 100 per cent of capital. If the investor wants to invest 100 per cent of his portfolio in Hong Kong or Chinese equities, they can expect a higher return but also much higher risk. If they need their money back in two to three years time, it is likely they are going to have a pretty big gap to fill, if the market turns against them.

The portfolio monitoring process involves a number of quality controls. The first one is that the strategic asset allocation does not breach the investor’s risk profile, explains Mr Mattoli.

“In 2006-2007, leading up to the crisis, the equity bull market was really taking off in the region and equity positions in clients’ portfolios grew at such a pace that, if not rebalanced, would have gone beyond the upper limit of equity strategic asset allocation.”

In a discretionary mandate, the bank automatically implements the rebalancing against the agreed benchmark, but in advisory mandates, the decision is up to the client. “Generally people get carried away along with the bull market,” he says. Market risk can be mitigated through diversification, and bulk positions, where 10 per cent or more of the portfolio is invested in any stock or bond, must be closely monitored.