Enterprise risk includes all of the factors that can affect an enterprise: market factors, reputation, regulation, compliance, operations, and legal risk are among the most prominent. Enterprise risk analysis, which uses stress tests and scenario assessments to estimate investment risks across asset classes, has become increasing popular with institutional investors, who understand the impact enterprise risk can have on their portfolios. But while enterprise risk analysis works well with traditional asset classes, using enterprise risk analysis on alternatives – such as hedge funds, private equity, and real estate – presents challenges.
This, at least, is the view of BNY Mellon and affiliate HedgeMark, as articulated in their January 2016 white paper Considering the Alternatives: A Practical Look at Enterprise Risk Analysis and Alternative Investments. The paper explores the impact of incorporating alternative investments into enterprise risk analysis and looks at how different approaches to data management can impact the resulting conclusions.
Evaluating Risk Across the Portfolio
“With a sharper focus on risk by regulators and other stakeholders, many institutional investors seek a fuller picture of how risk operates across investments within an entire portfolio,” said Frances Barney, head of Consulting-Americas for Global Risk Solutions at BNY Mellon, in a recent announcement. “Data is getting more and more critical and investors need to be informed and comfortable with the assumptions of their risk assessment, otherwise, they can come out of it with a false sense of security about their portfolio.”
The paper’s key findings and insights into best practices include:
- A “granular approach” to risk evaluation is preferable, with position-level information for all asset classes “the gold standard.” This kind of position-level transparency, liquidity, and control may be available in dedicated managed accounts and liquid alts, as well as traditional hedge funds.
- Information accuracy is obviously important, and that’s why the paper argues for single-vendor sourcing of investment data. Using a single vendor promises uniform data, whereas drawing data from multiple sources increases the likelihood of errors.
- Different approaches to data management can lead to different conclusions about risk. Having a different approach for each asset class can be problematic, which is why many firms are establishing a Chief Risk Officer position to evaluate risks across all asset classes.
- Consistency is especially important in light of the regulatory environment. Some regulators already require reports on stress testing and scenario analysis, through Form PF for U.S. investment advisers to hedge funds; and pursuant to Solvency II for insurance companies, and UCITS for European investment funds.
“We’ve learned the most crucial component is the veracity of the underlying data, which becomes even more important and difficult to manage as more opaque assets are held in the portfolio,” said Ms. Barney.
Jason Seagraves contributed to this article.