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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
Copyright:Attribution Non-commercial


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Fine tuning
Daniel Broby sees the relationship between the investment and performance teams as being as integral to each other as the workings of a well designed racing car. Here he outlines how best these teams might interrelate

he investment team is often seen as the engine of fund management performance and the performance team as the instrument panel. The latter complete with speedometer, fuel gauge, temperature and RPM counter. It is easy to fall into the trap of believing the engine can win the race without such bells and whistles. If they


are really unnecessary, none of the latter would be included in a Formula 1 car. Likewise, in order to win at fund management, performance measurement is equally necessary. The best fund managers, as a result, use performance teams to provide insights as well as measurement and attribution. Considering this important insight, the topic of what investment teams

need from performance teams is insufficiently addressed. The seamless integration between the middle office and the rest of the firm is just part of the story. This integration should be combined with useful interaction and all too often this element is missing. The other thing to take into account in discussing the role of performance teams in a fund management


PMCRR I Autumn Volume 3 Issue 1

I interdepartment relations

organisation is that the investment world has entered a new return paradigm. Correlations have proved higher than history would have suggested and volatility appears to have structurally changed. Clearly the environment we find ourselves in requires more internal support for the investment processes and a higher profile role for performance and risk teams. I believe it is now incumbent on portfolio managers to know when positive alpha morphs into beta on the downside. Performance measurement and attribution provide the statistical tools to help flag when this might be happening. Performance teams should be structured to track such dynamic changes in the marketplace, not just calculate total and relative returns for reporting purposes. In this respect, as a bare 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; and ➜ where the portfolios conform to strategy objectives and the macro view. The goal is to ensure that portfolios are managed according to guidelines and are consistent with the clients’ risk appetite and tolerance. The ability of the performance team to monitor rapid changes in risk is another main component of this area. Hedging and overlays can then be used by the investment team to respond to changes in the investment environment. In order to make any interaction work in practice, it is important for the performance team to maintain a robust database. In the racing car analogy, this is equivalent to having an on-board computer. The minimum systems should include: ➜ the ability to monitor hard/soft limits on certain sources of risk

(ie, concentration limits such as sector limits and asset class risk budget allocation limits); ➜ the ability to produce exposure, contribution and attribution reports; ➜ the ability to produce risk reports, including tracking error, diversification of the portfolio and portfolio characteristics; ➜ the absolute oversight of risk and/ or tracking error targets or limits; ➜ position reporting; ➜ risk management systems, typically factor-based; and ➜ systems that oversee the use of leverage. The nature of the interaction between investment and performance teams also depends on whether an absolute or relative return approach is taken. Indeed, this aspect also impacts the reporting function and the way a performance team interrelates with clients. In effect, the performance team should help the clients understand what they are being charged for (hopefully risk adjusted outperformance). This is where the performance team can add strategic value to an organisation. The distinction between benchmarks and indexes has been illustrated in the book A Guide to Equity Index Construction, in addition to the trade-off between breadth and inevitability, rebalancing versus costs, and rules versus value judgements. I believe these are all areas where investment teams can benefit from input from the performance team. In this new post-credit crisis world in which we live, I cannot fail to mention the role of performance teams in risk measurement and assessment. Indeed, portfolio risk control is central to the middle office function. Throughout my career, I have noticed that the investment process is increasingly embracing risk as both integral and iterative to its success. It is now common for the performance and

risk teams to meet with the portfolio managers and discuss the various issues. Initially, this was driven by the desire to answer investment consultants but increasingly it is being driven forward by the desire to understand ever more complex markets and financial instruments. With the continued presence of hedge funds, shorting and leverage, this will continue. The next step, as a result of this, will be for new risk measures. VaR (for more on VaR see page 31), tracking error and factor models have all proved themselves lacking in some vital respects. It is incumbent on the performance team — not the investment team — to introduce these measures. Although new priorities and challenges can sound daunting, I believe fund managers gain a competitive edge by having a fully integrated risk, performance and investment team. To achieve this, the middle office portfolio risk control should 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, forwardlooking risk assessments; ➜ identifying the underlying drivers of risk and return across asset classes and complementing quantitative 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 by beating the competition and, as such, the performance team is often charged with monitoring competitor funds. Indeed, the comparison of fund returns

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There will, however, always be conflicting forces between impartiality and the demands from marketing
with a competitor’s is the most common method of evaluating fund performance at the firm level. As part of this function, feedback should be passed on by the performance team to the investment team on competitors’ positioning and their largest holdings. It is always good, as Sun Tzu observed in The Art of War, to know your competitors. There will, however, always be conflicting forces between impartiality and the demands from marketing. Fortunately, we now have the CFA Institute supported GIPS (Global Investment Performance Standards). These standards provide an institutional framework on which the performance team can build a professional offering. In structuring the middle office, senior management should understand that risk and performance techniques are often seen as complex and black box in structure. The output of performance teams can be difficult to interpret and communicate to investment teams. The role played by the Professional Risk Managers’ International Association (PRMIA) in this respect is important. PRMIA raises the professionalism of the performance and risk profession. Indeed, any professional qualification, such as the Certificate in Investment Performance Measurement (CIPM), makes for better interaction between the performance and the investment team. Any well-built racing machine needs precision to win the race. This precision is what a well structured performance team brings to a well structured investment team. There are a number of internal processes that can be applied to ensure the systems and controls are both up to the job. They include analysis of data, the risk management function, an integration of qualitative judgment with quantitative analytics, an assessment of liquidity and counterparty risks and enhanced risk analytics, including stress testing, factor analysis, tail risk and multiplehorizon modelling. In this respect, I look forward to the day when performance teams and investment teams are as seamlessly integrated as the workings of a well built racing car. I PMCRR

Further reading

Broby, DP. A Guide to Fund Management. Risk Books (2010); ISBN-13: 978-1-906348-18-2 Broby, DP. A Guide to Equity Index Construction. Risk Books (2007); ISBN-13: 978-1-904339-77-9


PMCRR I Autumn Volume 3 Issue 1

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