Staying Ahead in Difficult times: Tools that deliver

Mr. Sprackling, what is the value of stress testing and scenario analysis to fund managers?

Scenario analysis and stress testing mean different things to different people. Several years ago, the way that many of the old systems worked was that you would have a very fixed set of parameters that you would test. You would build actual historical scenarios, such as the collapse of Long Term Capital Management in 1998, in order to recreate those conditions and apply them to current portfolios.

More recently managers have been using stress testing, where you can shock the curves for, say, interest rate inflation or volatility. Interestingly, at the end of last year the FSA released a discussion paper for anyone who manages funds saying that a) you must be performing stress testing and b) they recommended a way of doing this, which they call ‘reverse stress testing’.

This is where a firm will identify its vulnerabilities and come up with the conditions that would actually cause their business to fail in that scenario. This is a big departure from the VaR-based approach, as the fact is that VaR didn't save us from the credit crunch.

What managers should be doing at the moment with their Risk Management procedures is not just looking to past conditions to predict the future, as this has not proved reliable. If we learn any lessons from the credit crunch, it is that no-one expected it, and so no-one modelled it and no one was prepared for what happened to both liquidity and volatility in the market.

This is why it is important to highlight the difference between scenario analysis and stress testing - and why it is pointless just modelling past events. All financial firms are to some extent now required to meet tougher liquidity standards. Stress and scenario testing, especially for liquidity risk, is now both a regulatory obligation as well a key fund management tool.

Do you see any changes in how people are actually adopting stress testing and scenario analysis in a stress testing context?

People have been talking about it but many firms are yet to implement it fully in the buy-side.

The big change is that you have to look forward now, rather than backwards. Indeed it’s more than just looking forward– it’s expanding the time horizons of how far ahead you look.

Modern institutional managers are starting to behave like hedge fund managers, so what they need on their desktops is a view of their portfolio holdings, what their current performance is, what the risks of that portfolio currently are, and the ability to stress test and check scenarios to see what effects changes in market conditions are going to have on that portfolio.

Fund managers used to take performance for granted, could do it in their heads - but now they have to get positive returns, must be much more precise - looking at P&L and risk, sector by sector and so on; thus the ability to decompose performance is absolutely essential. Fund Managers aren’t just doing individual trades; they are doing a number of trades to fit a certain investment strategy. They therefore have to be able to check the performance of that strategy to see whether or not it worked.

So, it’s an absolutely core fundamental requirement in terms of being able to be competitive in the future?

Absolutely, there have been times in a bull market where some fund managers wouldn’t even have to bother looking at their performance, because they knew roughly what it is in their head.

Now however, with more internal and external regulatory oversight, and with more savvy clients demanding this kind of information, all your peers are trying to out-do one another and trying to get positive returns in a very volatile market. You have to be very precise in what you are doing.

What has changed with regard to attitudes to client reporting and the value of historical data?

Things have changed significantly in recent months and there are a number of reasons for this – first we’re emerging from the most volatile period in the capital markets for nearly a hundred years, and with the still present threat of redemptions hanging in the air, every manager is focussing on retaining and creating happy customers.

Client reporting is actually often the only interface you have to your customer. Certainly, a lot of my clients at the moment are thinking about their client reporting, upgrading the form and content of reports. A few years ago many were outsourcing this function, this has now reversed itself and more managers are retaining and enhancing their in-house capabilities.

A client report can have a number of things in there: a list of transactions, risk data, performance data, some commentary from the fund manager and so on. The data that underpins this often comes from completely different places and systems in an organisation: transactions may come from the front office systems, the holdings will come from the back office systems, there may be separate risk and performance systems and so on, and that creates multiple challenges in trying to collate and aggregate that data, reconcile it and make sure that it is correct.

And, it’s not just client reporting – what a lot of managers want is a place to find historical trends, to see what has been happening over the last few years. Trustees are very keen on having a full auditable history. That proves very difficult to do, but with InvestmentManager you have everything there in one database.

How long have you been aware of InvestmentManager as a solution?

The first time I heard of InvestmentManager must have been 5 or 6 years ago and the client that used it loved it. Since then I’ve seen the system evolve enormously in the amount of functionality it has, as well as the look and feel of it.

It has become very easy to use and very intuitive. It gives certain functionality that you can’t find anywhere else – there are a few competitors but they are few and far between.

About Sean Sprackling

Sean Sprackling is a Partner at Investment Solutions Consultants LLP, the leading Investment Management Consultancy. With over 16 years experience gained while working for a variety of investment managers, system vendors and consultancies, including Citisoft and Bluerock Consulting, where he was Head of Investment Management, Sean specialises in Fixed Income and Derivative issues.

Sean has recently been advising a number of clients on the creation of their target operating models for increased derivatives trading, setting up risk management functions and launching innovative new products. Sean is a regular speaker on the conference circuit and is the author of a renowned web-site tracking current derivatives issues in Investment Management.

Sean holds both Bachelors and Masters Degrees from St Catharine’s College, Cambridge.

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