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PMCRR Aut Vol 3, issue 1

PMCRR Aut Vol 3, issue 1

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Published by Daniel_broby
The relationship between investment and performance teams.
The relationship between investment and performance teams.

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Published by: Daniel_broby on Oct 15, 2010
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10/15/2010

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6PMCRR
I
Autumn Volume 3 Issue 1www.pmcrreview.com
Fine tuning
Daniel Brobysees the relationship between the investment and performance teams asbeing as integral to each other as the workings of a well designed racing car. Here heoutlines how best these teams might interrelate
 T 
he investment team is oftenseen as the engine of fundmanagement performanceand the performance teamas the instrument panel. Thelatter complete with speedometer, fuelgauge, temperature and RPM counter.It is easy to fall into the trap ofbelieving the engine can win the racewithout such bells and whistles. If theyare really unnecessary, none of thelatter would be included in a Formula 1car. Likewise, in order to win at fundmanagement, performancemeasurement is equally necessary. Thebest fund managers, as a result, useperformance teams to provide insightsas well as measurement and attribution.Considering this important insight,the topic of what investment teamsneed from performance teams isinsufficiently addressed. The seamlessintegration between the middle officeand the rest of the firm is just part ofthe story. This integration should becombined with useful interaction and alltoo often this element is missing.The other thing to take into accountin discussing the role of performanceteams in a fund management
 
7PMCRR
I
Autumn Volume 3 Issue 1
I   
i  nt   e d  e p at  m ent   el   at  i   on s 
organisation is that the investmentworld has entered a new returnparadigm. Correlations have provedhigher than history would havesuggested and volatility appears tohave structurally changed. Clearly theenvironment we find ourselves inrequires more internal support forthe investment processes and ahigher profile role for performance andrisk teams.I believe it is now incumbent onportfolio managers to know whenpositive alpha morphs into beta on thedownside. Performance measurementand attribution provide the statisticaltools to help flag when this might behappening. Performance teams shouldbe structured to track such dynamicchanges in the marketplace, not justcalculate total and relative returns forreporting purposes. In this respect, as abare minimum, they should monitor:changes to overall portfolio risk;
increases/decreases in sector
biases;increases/decreases to factor
exposures;reviews of risk and concentration
limits; andwhere the portfolios conform
to strategy objectives and themacro view.The goal is to ensure that portfoliosare managed according to guidelinesand are consistent with the clients’ riskappetite and tolerance. The ability ofthe performance team to monitor rapidchanges in risk is another maincomponent of this area. Hedging andoverlays can then be used by theinvestment team to respond to changesin the investment environment.In order to make any interactionwork in practice, it is important for theperformance team to maintain a robustdatabase. In the racing car analogy, thisis equivalent to having an on-boardcomputer. The minimum systemsshould include:the ability to monitor hard/soft
limits on certain sources of risk(ie, concentration limits such assector limits and asset class riskbudget allocation limits);the ability to produce exposure,
contribution and attributionreports;the ability to produce risk reports,
including tracking error,diversification of the portfolio andportfolio characteristics;the absolute oversight of risk and/ 
or tracking error targets or limits;position reporting;
risk management systems,
typically factor-based; andsystems that oversee the use
of leverage.The nature of the interactionbetween investment and performanceteams also depends on whether anabsolute or relative return approach istaken. Indeed, this aspect also impactsthe reporting function and the way aperformance team interrelates withclients. In effect, the performance teamshould help the clients understandwhat they are being charged for(hopefully risk adjusted out-performance). This is where theperformance team can add strategicvalue to an organisation.The distinction betweenbenchmarks and indexes has beenillustrated in the book
 A Guide to Equity Index Construction
, in addition to thetrade-off between breadth andinevitability, rebalancing versus costs,and rules versus value judgements. Ibelieve these are all areas whereinvestment teams can benefit frominput from the performance team.In this new post-credit crisis worldin which we live, I cannot fail tomention the role of performance teamsin risk measurement and assessment.Indeed, portfolio risk control is centralto the middle office function.Throughout my career, I have noticedthat the investment process isincreasingly embracing risk as bothintegral and iterative to its success. It isnow common for the performance andrisk teams to meet with the portfoliomanagers and discuss the variousissues. Initially, this was driven by thedesire to answer investmentconsultants but increasingly it is beingdriven forward by the desire tounderstand ever more complex marketsand financial instruments. With thecontinued presence of hedge funds,shorting and leverage, this willcontinue. The next step, as a result ofthis, will be for new risk measures.VaR ( 
for more on VaR see page 31
 ),tracking error and factor models haveall proved themselves lacking in somevital respects. It is incumbent on theperformance team — not theinvestment team — to introducethese measures. Although new priorities andchallenges can sound daunting, Ibelieve fund managers gain acompetitive edge by having a fullyintegrated risk, performance andinvestment team. To achieve this, themiddle office portfolio risk controlshould be designed for:accommodating changes in
investment philosophy or process;capturing securities held outside of
mandate;compliance or regulatory issues;
counterparty and liquidity
management;delivering qualitative, forward-
looking risk assessments;identifying the underlying drivers of
risk and return across assetclasses and complementingquantitative risk measures;measuring manager turnover;
stress testing and extreme risk
measurement capabilities;detecting deterioration in
performance;detecting style drifts; and
transparency.
Performance success is aided bybeating the competition and, as such,the performance team is often chargedwith monitoring competitor funds.Indeed, the comparison of fund returns

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