Risk Management Consumes Buy-Side Traders Amid Volatility

The buy side learned many important lessons in 2008, not the least of which is that good risk management is necessary at all levels of the investment process. With market volatility hitting all-time highs and "counterparty risk" now a household term, buy-side traders are heeding the risk management call.

Whether they are communicating more frequently with internal risk managers or employing risk analytics and tools more diligently, traders are now more actively assessing risk and weighing risk management best practices. But the buy side still faces challenges in shoring up the risk management framework on the investment management side.

According to Adam Sussman, director of research at TABB Group, data -- more specifically, timely data -- is at the heart of the risk management issue for buy-side traders, as well as for portfolio managers and risk managers. "In some cases, identifying the right data is often about knowing what data to avoid," Sussman explained in a recent TABB Group paper.

"This is the classic challenge of distinguishing the signal from the noise. In a world where we are overloaded with data and ways to slice and dice that information, it is important to know what is not important," he continued. "If someone is trying to make a projection of the most likely outcomes, then it may make sense to ignore outlier data points. On the other hand, if you are conducting a stress test, then these outliers are highly relevant."

The type of data required also varies based on who is using it, wrote Sussman in the paper. "Portfolio managers, traders, [and] operations and risk managers value data based on its contribution to the process. In fact, each component of the investment life cycle has different requirements for the same set of data, including time horizon, frequency, weighting and others."

Finding the Time

One area in which traders continue to struggle with risk management, Sussman tells Advanced Trading, is gauging the appropriate risk time horizon for analysis and timing their executions. "No trader wants to be executing at the top or bottom of the market, and it's a challenge to figure out how to trade in such a volatile market -- how to balance getting the trade done for the portfolio manager without taking on too much execution risk or moving the market too much," he relates.

Sussman explains that most risk analytics that are built for traders take a long-term view of market risk, equally weighting historical and current data, which is not as applicable in today's environment. "So there has to be a balance between pre-trade analytics that are looking back over a longer period of time and then looking at what is going on today," he asserts. "That's the challenge -- managing the risk the trader is taking on when executing that trade."

According to Sussman, however, closer-to-real-time models would help traders navigate the volatility. "There is a gap between the information used on the portfolio side and the information used on the execution side, and I don't think it needs to be as wide as it is today," he says, noting that a lot of the relevant data already is used for equity risk models on the portfolio management side and that even algorithm providers leverage similar data in their offerings. But, "It doesn't seem like anyone has taken that data and made tools suited for the buy-side trader," Sussman adds.

"Some of the fundamental and statistical factors that are being used to figure the volatility of a portfolio or variance of returns of the portfolio can also be useful for traders -- they just need to be tweaked for that analysis," he continues. Sussman points to the correlation of the movement of two stocks as an example of data leveraged in a portfolio risk management tool that also could be utilized for a buy-side-specific risk tool. "There is a lot of rich data, but there needs to be more of an emphasis on the short-term predictive qualities of that data," he says.

Predicting Volatility

"If you can use models that try to predict volatility, then it can help traders decide how quickly they need to trade," Sussman explains. "If a portfolio manager says, 'I want to get out of this quickly,' [but] it's a low-volatility stock, then the trader can go back to the portfolio manager and say, 'Well, there's a better way to trade this if we do it slowly.'"

While Wilmington Trust applies risk management at all stages of the trade life cycle, Stephen Davenport, the firm's director of equity risk management, acknowledges that the current volatility presents challenges. "The intraday volatility is making the market very treacherous -- you make a decision and wait and find out an hour later the market is down 5 percent and maybe the decision isn't valid anymore," he relates.

His advice? Be patient and wait for trends to develop, but be prepared to take advantage when an opportunity presents itself. "Where there is liquidity and opportunity, you have to take advantage," Davenport stresses. "Make sure you don't try to force an idea or a viewpoint; if the market is not showing you reasonable spreads or reasonable liquidity, then there's probably a reason not to go into that particular trade."

Davenport also advocates open communication as a key to better risk management. "I interact with traders almost every day and talk about where the market is," he says. "When we have trouble getting a trade done, then we talk about whether to take it upstairs or do something different with it and explore other sources of liquidity."

Experience Wanted

In addition, experienced traders are a plus. "The experience of traders is a big asset as well -- they've seen some of the troubles in the Asian markets and what happened in 2000," Davenport says. "It helps to have experienced traders because they know when to step away and when to try to get a trade done and get out before the market moves too quickly in a given direction."

Davenport adds that volatility is likely here to stay, making risk management strategy even more vital. "The volatility level is extraordinary -- it's unlike anything we've ever seen," he reports. "And it looks like it's going to stay here for six, nine months -- maybe even a year."

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3 Data Pitfalls

There are three specific data pitfalls that can obscure risk analysis at the portfolio manager and risk officer levels, according to Adam Sussman, director of research at TABB Group:

1. Out-of-Sync. The frequency of the risk data updates lags behind the fast- moving markets. Similarly, the time horizon of the analysis can be misaligned with the investment objective of the portfolio.
2. Opacity. Unfamiliarity with the model behind the analytics puts people at greater risk of making bad decisions.
3. Rigidity. By looking at the same data in the same way, funds are more likely to be negatively impacted by one another. Similarly, approaching risk from a too narrow or rigid viewpoint can obscure vital changes to the risk of a portfolio.