Risk Management and Managed Futures

One of the key elements of the investment process in any investment strategy is risk management. The inherently different nature of alternative investment strategies (AIS) compared to traditional investments and the diversity within the AIS universe itself presents different challenges to the risk manager. The importance, too, of active risk management is increasingly being recognized by institutional investors. However, the sources of risk to be evaluated are sufficiently diverse within each strategy that many institutions and investors are technically incapable of assessing and monitoring this risk profile.

 

Granite believes that within the AIS field, Managed Futures is by far the best prepared to withstand the scrutiny of risk managers. To a large degree this is due to the institutional safeguards and transparency of the futures industry but also to the important active risk management role played by organizations such as ours.

 

Risk managers typically distinguish between different types of risk. None of these is unique to Managed Futures though experience tells us there are different factors which must be taken into consideration.

 

Risk Categories

 

Market Risk

Risk of loss from a change in the value of traded assets

Credit Risk

Risk of financial loss suffered from the default of a counter party

Liquidity Risk

Risk of loss due to the inability to transact business at normal bid/ask spreads

Operational Risk

Risk of financial loss due to the failure of internal systems or people

Diversification Risk

Risk of unforeseen correlations altering the market risk of a portfolio in unexpected ways

Manager Risk

Though closely related to operational and diversification risk, this relates specifically to the unexpected or unforeseen event directly affecting a specific CTA firm (e.g. a merger, personnel turnover, change in investment process etc)

Fraud Risk

Risk of loss due to fraud

Regulation Risk

Risk of changes in the regulatory framework

Legal Risk

Risk of not being able to enforce claims

 

 

 

What follows is a brief description of Granite’s own approach to the evaluation, monitoring and mitigation of risk within our area of expertise.

 

 

Market Risk

 

I. Post-investment Risk Management: Position and Exposure Monitoring

 

The monitoring of the exposures within the portfolio are based on live information about positions, transactions, orders and margins provided by the executing/clearing brokers and exchanges. The exposures are aggregated at the contract, manager and portfolio level. Furthermore, the P&L at each of these levels is calculated live on a marked-to-market basis and a daily Net Asset Value is provided at close of business.

 

The platform for this information is eCIS, a web-based system developed and maintained by Cargill Investor Services.

 

Surveillance and monitoring practices employed:

 

In addition, for non-capital guaranteed investments, we recommend investor’s issue an ‘exit letter’ authorizing the liquidation of all open positions.

 

II. Post-investment Risk Management: Evaluation of Market Risk

 

The quantification of risk is established through two different complementary methods:

 

Initial Margins: Defines the amount of security required to hold per contract. Margins describe the probabilistic expected change in value of a futures contract in any one day within a degree of certainty and are determined by the exchange on which they trade. Margins on futures are determined using the actual historical volatility exhibited by each contract. In the case of Options they are determined using standard option pricing models and implied volatility. Margins regulate the degree of leverage available in the futures markets and adjust up and down, sometimes on short notice, as market conditions dictate. Periods of increased volatility or market uncertainty result in increased margin requirements.

 

In many cases, higher margins are required from speculative accounts than from hedging accounts. This recognizes the fact that these accounts hold no exposure in the underlying commodity or asset to use as “offset”.

 

SPAn Margining: An acronym for Standard Portfolio Analysis of Risk, this is a system of assessing the initial margin requirements for combinations of contracts. The system calculates how the value of a portfolio responds to changes in future’s prices and volatilities. Particular combinations: “Spreads”, Option strategies and combinations of Options and Futures, may attract reduced initial margins acknowledging their lower exposure to market risk.

 

These initial margins requirements are subject to continuous review by the exchanges and clearing houses. The margins are tested in simulations of stressed market conditions to ensure they provide adequate cover.

 

For more information on SPAN margining and similar applications, please see:

Chicago Mercantile Exchange            http://www.cme.com/risk_management/span/index.cfm#4

 

 

Margin-to-Equity Ratio Monitoring

Continuous monitoring of Margin-to-equity ratios at the manager and portfolio level leads to:

·                  an understanding of each manager’s and the portfolio’s behavior in various market conditions,

·                  detection of previously unknown or unrecognized risks in strategy or sudden ‘style-shift’ in the manager,

·                  recognition of undesired or unpermitted leverage,

·                  possibility of trading manager control, and

·                  identification of opportunities for leveraging/deliberating investments.

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Credit Risk

 

One of the defining features of Managed Futures within the Alternative Investment field is that all trading is conducted on recognized exchanges complemented by a Clearing House system. Through the policies instituted the protection of client funds and the enforcement of contract obligations is possibly the best of any market.

 

The Exchange Clearing House*

Through the process of novation the Clearing organization becomes the “buyer to every seller and the seller to every buyer”. The purpose is to provide a mechanism that assures the payment of all gains and collection of all losses on a daily basis. In effect, the clearing house becomes a counter party to every transaction and guarantees the performance of Clearing Participants.

 

Clearing House Guarantees: Sydney Futures Exchange Clearing House (SFECH)

To prevent any systemic collapse, the Clearing House monitors the settlement margins of each participant and any exposure resulting from a disproportionate share of open positions in any contract. It also imposes Capital based position limits on clearing members. For example, it maintains that each member’s initial margin cannot exceed 200% of their Net Tangible Assets. In these ways, the Clearing House maintains control of the system as a whole.

 

However, upon default by any Clearing Participant, the Clearing House has access to a Financial Guarantee fund. In the case of the SFECH, the fund currently sits at approximately A$150 million including a A$10 million tranche from the Sydney Futures exchange, between $A60-$A90 million from Clearing Participants and up to A$80 million in an insurance component.

 

Segregated Accounts*

Firms and principals of firms in the futures industry are required to maintain their customers’ funds and margin deposits in bank accounts which are totally separate from their own. Rules further stipulate that such funds can be used only for the purposes the customers intended and can at no time be co-mingled with the firm’s funds or the funds of the firm’s principals. Compliance is strictly enforced and regulators possess power to take such immediate actions as is considered necessary to protect the security of customers’ money.

 

Capital Requirements*

Every firm that conducts business with the public as a Futures Commission Merchant must have and maintain sufficient capital to meet its financial obligations to its customers. These requirements are subject to continuous audit and stringent enforcement. Regulatory agencies have the authority to determine compliance on a daily basis and in volatile markets clearing organizations can demand that a firm provide additional capital on one hour’s notice!

 

Transfer of Market Positions*

Should a firm be determined to be in a financial situation that could potentially jeopardize the safety of its customers’ funds, it can be directed to immediately cease operations and transfer all open customer positions in the market to a firm which is financially sound. This is to ensure that adequately margined positions with a troubled firm will not be liquidated at a time when the  customer may not wish for them to be liquidated.

 

Corporate Capital Guarantee in event of Exchange collapse

For accounts in excess of US$20m Granite may arrange a corporate capital guarantee. This guarantee will protect the capital held in the account in the event of a collapse of an exchange on which contracts are held. Granite knows of no other firm that will provide such a guarantee.

 

Finally, in addition to the above institutional arrangements, Granite recommends only the most financially secure FCMs be engaged for clearing and execution. Consistent with Granite’s own policy we also recommend that only firms with a strict ‘no proprietary trading’ policy be engaged.

 

*Excerpts from National Futures Association – “The Financial Integrity of Futures Markets”

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Liquidity Risk

 

The liquidity of a market is distinct from the liquidity of a portfolio. For this reason, the risk manager should first evaluate the institutional arrangements of the futures industry and then the liquidity of the assets in the suggested portfolio. In evaluating liquidity, the risk manager should remember that:

 

·                  liquidity is not the same as market depth. A market with significant turnover is inherently no more stable than a small market, and

·                  liquidity is equally dependent on the investment horizons of the various participants.

 

Open Access and Execution of Trades

Each Futures exchange is responsible for the fair and efficient conduct of trade. Each has well established and policed policies on trading rules which:

·                  govern the sequence in which orders are executed,

·                  prohibit the pre-arrangement of trades,

·                  prohibit the withholding of orders,

·                  prohibit the post allocation of trades,

·                  prohibit the front running of orders, and

·                  governs the trading of personal and principal accounts.

 

The combined aim of these policies is to ensure all participants are treated equally and fairly.

 

Abuse of Market Power and Systemic Instability

Most, if not all, Exchanges invest significant resources in market surveillance. Market conditions and activity are monitored on a continuous basis and many contract markets have pre-established limits on position size and market moves.

 

Daily limits define the allowable point move of any contract. If activated these may result in a pause in trading or a complete halt. Usually, trading is allowed to continue after “breaks” in trade but should the market continue in the same direction, further “breaks” will be imposed until finally trade is suspended. It is important to note that these limits are imposed on both the upper and lower sides of a market move.

 

Many exchanges have defined reporting levels and position limits on contracts to restrict the accumulation of market power. This is to prevent price manipulation and to ensure there remains sufficient liquidity to facilitate continuous pricing.

 

Post-investment Risk management

At the portfolio and manager level, Granite reviews the underlying commitments of each manager in the context of the prevailing market conditions. Special attention is given to identifying :

 

·                  holdings of contracts in markets with poor open interest,

·                  any excessive concentration of holdings in any one market, and

·                  any concentration of holdings with potential converging correlations.

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Operational Risk

 

I. Pre-Investment Risk Assessment

Granite reviews the structure of the CTA firm to understand its operational procedures and to ensure the integrity of the organization. Assessment at the manager level leads to an understanding of the:

 

·                  responsibilities carried by individual personnel,

·                  decision-making processes and roles played by individual personnel,

·                  market coverage and monitoring capacity of the firm,

·                  compliance policies and practices of the firm,

·                  firm’s capacity for growth,

·                  firm’s trade execution process,

·                  firm’s accounting, review and client reporting practices, and

·                  firm’s structure of information systems, backups and disaster recovery plan.

 

 

II. Post-Investment Controls

 

Surveillance and monitoring practices employed:

With CIS we impose controls and monitor the orders entered by managers. In this way we ensure the manager stays within the mandate as defined in the Disclosure Document. We define which contracts are traded, pre-determined limits on contract size and the margin-to-equity ratio. No order will be accepted which would, in its effect, breach any of these parameters.


 

 

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Diversification Risk

 

I. Asset Allocation at Pre-Investment Level

 

Diversification from Traditional Assets

Risk issues are addressed at the pre-investment level through a structured evaluation of the client’s specific needs and constraints (objective, expected return/risk, liquidity, instruments, correlation, etc). Ideally, a correlation analysis within the investor’s entire portfolio should be undertaken. Unfortunately, many private investor’s are reluctant to divulge complete information. This restricts our ability to construct the portfolio most appropriate for the individual’s circumstances. It is our objective to construct customer specific portfolios with detailed risk catalogues.

 

Diversification in Different Trading Strategies - Top Down Approach

Granite carefully and thoroughly investigates volatilities and correlations between the different strategies employed by managers and between the different market sectors in which they invest. It is Granite’s goal to reach a high level of diversification through investments in uncorrelated managers. 

 

The performance data collated by Dan B.Stark & Co is first categorized by trading approach. That is, whether the CTA investment approach is best characterized as systematic or discretionary. Then each is allocated to a category based on the broad sector in which they invest:

 

Finally, the firm is identified by further categories based on the exact sector in which they invest:

 

From these categories Mr. Stark has developed indexes which are used to compare the performance amongst the different strategies employed by CTA firms. Each CTA’s performance can be compared to it’s peers within the same category or to the broader industry. Correlations and risk adjusted returns can be evaluated from this data.

 

 

Diversification amongst Managers – Bottom Up Approach

Individual investment strategies are assessed qualitatively and quantitatively. Only managers with strategies that are fully understood are selected. Strategies that cannot be followed in detail are avoided. The central questions asked are: ''Why does this manager make money?'' and “Does this mean they will continue to make money?”. A conventional way of assessing managers has been adopted within the equities, bond and alternative investment industries. This methodology is typically characterized as the “Four, Five or Eight P” approach. Granite and other consultants focus on:

 

 

 

II. Asset Allocation at Post-Investment Level

 

Depending on the risk/return characteristics of the positions, active leveraging and de-leveraging may be part of the risk management of the product. Higher market volatility, for example, induces higher risk on existing positions, and should lead an investor to deleverage positions in order to reduce exposure. A reduction of risk due to a reduction in market volatility should enable the portfolio manager to increase leverage. 

 

Understanding the performance characteristics of the manager’s strategy and how it relates to the prevailing market conditions or other managers within the multi-manager portfolio is where a large part of the “art” of investment management lies. Only complete familiarity with these aspects enables a manager to make consistently high quality judgments.

 

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Manager Risk

 

Thorough Manager Due Diligence Process

As discussed under the heading “Operational Risk”, Granite strives to understand the manager’s internal risk management procedures in combination with the risk characteristics of the strategy itself. This enables us to document a detailed risk catalogue for the individual manager.

 

In fully understanding the investment strategy and monitoring the market activity and performance of the manager, Granite is attempting to identify any early evidence of “style-drift”. Any alterations in the behavior of the manager can impact the investment performance.

 

Manager surveillance

As long standing members of the Futures Industry, the principals of Granite maintain excellent relationships with senior officials of exchanges, representatives of Futures Commission Merchants and the managed futures community. This network provides an invaluable supply of intelligence  to ensure the integrity of investments.

 

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Coping with Fraud

 

The risk of fraud is not limited to alternative investments. However, experience would indicate that it occurs most often when investments are opaque. For example, there are many high profile examples of fraud occurring in the hedge fund industry. This in no small part has been due to the refusal of managers to disclose their practices or offer transparency, thereby creating an opportunity for unscrupulous people. Whilst these tales make for good newspaper sales they often do not present a balanced view of an industry.

 

Nevertheless, a prudent risk manager should always satisfy himself or herself that an investment is all that it purports to be.

 

Policies, however, can be employed to limit the opportunity for fraud:

 

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Regulation Risk

 

Historical performance of country, openness and free market, market interference, capital constraints

* historical demonstration of free markets and openness, limit exposure in countries with history of market interference, capital restraints etc

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Legal Risk


 

 

 

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