Institutional Investor's Alpha Magazine - May 2008 - (Page 63)

[ample] liquidity are likely to be drawn, VaR is completely inappropriate,” he adds. “But for a long-short equity analysis, it is a useful tool.” Movchan, who has been running risk analysis at Alexandra for 12 years, says experience helps him decide how to use the tools in the risk software suite he gets from New York–based Imagine Software. Each day he produces a report that runs seven to nine pages and gives a broad snapshot of the ﬁrm’s risk exposure. Similar risk analyses were being run at UBS and Dillon Read. But the conclusions were often wrong. In its dense, 50-page April report on its losses, complete with a three-page glossary ﬁlled with deﬁnitions of such instruments of modern ﬁnance as credit default swaps and collateralized debt obligations, UBS offered one of the more detailed looks at how a risk management system failed in the recent market meltdown. One of the problems at UBS and Dillon Read was that too much of the number-crunching was being done with VaR calculators, which do not take into account liquidity issues. They are based on assumptions of “perfect” markets, or those in which there are always buyers and sellers. Instruments like mortgage-backed securities, which have inherent liquidity risk, are ill suited to basic VaR analysis. That problem was compounded by reliance on overly rosy credit ratings that agencies like Standard & Poor’s placed on mortgage-backed securities. Even a stress test to determine how those securities would perform under adverse conditions missed the mark, because the data included an assumption that they would hold their value. That gave the green light to traders to leverage up on mortgage-backed securities. When defaults skyrocketed, the MBS market collapsed — and so did Dillon Read. Steven Harrison, president and co-founder of Imagine Software, says some ﬁrms did a ﬁne job of forecasting potential problems. The secret was not necessarily in their chosen software, but rather in doggedly raising questions about the underlying assets in mortgage-backed securities, Harrison says. A risk manager who bothered to look inside the baskets of securities being traded would have discovered stacks of default-prone subprime loans. With that information in hand, stress tests, which could be constructed on Imagine’s software, would have shown the true risk exposure. “If you are making a billion-dollar bet,” Harrison says, “you are supposed to be analyzing what is really in this basket that somebody sold you.” What leads a risk manager to ask the right questions, run the right tests and avoid the pitfalls of using the wrong tools for the job? Rahl says experience counts for a lot, especially with the complex nature of derivatives and the equally complex risk management systems used for analysis. But the rapid growth of hedge funds — there are now an estimated 10,000 worldwide — has made it tough to ﬁ nd talent. As a result, some ﬁ rms have relatively inexperienced risk managers. “There are an awful lot of very smart people in risk,” Photo by Eric McNatt for Alpha Rahl says. “But there are also a lot of kids who are still wet behind the ears.” Andrew Aziz, executive vice president for risk solutions at Toronto-based risk vendor Algorithmics, believes that the recent focus on VaR is probably a good thing because it has caused ﬁrms to review their risk practices. Those that relied heavily on VaR to the exclusion of other risk models will now likely change their approaches. “I think going forward there will be few organizations that base everything on a simple VaR calculation,” Aziz says. “VaR won’t be discarded. For normal markets it is still a very useful measure.” As the subprime situation has shown, ﬁnding the right data to run tests can be a challenge in itself. To help him gather intelligence, Alexandra’s Movchan says he resorts to the decidedly low-tech technique of talking to people, both in his ﬁrm and elsewhere, in a constant search for any tidbit that might shed light on a trend or issue of importance. “In risk management only about a third is quantitative,” Rahl says. “A third is still a big part of the puzzle, so it is quite valuable.” The remaining two thirds of the puzzle is where good risk managers earn their money. Ultimately, an accurate forecast depends on knowledge, experience and chutzpah. “It has nothing to do with the computer,” Rahl says. “It has to do with wisdom and experience.” And perhaps a bit of luck. “Risk management is a lot more than VaR,” says Gregg Berman, co-head of the risk business group at RiskMetrics. MAY 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 63

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - May 2008

Institutional Investor's Alpha Magazine - May 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Send in the Clones The Good Guys: Outside the Box Cover Story: Welcome to Oz Interview: The Tipping Point Regulation: When Sentinels Go Astray Strategies: Taking Credit Research Center: The Hedge Fund 100 Book Excerpt: Shoot the Messenger Alpha Bytes: VaR Enough? Unhedged: Commentary: Not Your Father's Activist

Institutional Investor's Alpha Magazine - May 2008

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