How the research houses identify risks

Research Review is compiled by PortfolioConstruction Forum in association with Money Management, to help practitioners assess the robustness and disclosure of each research house – especially given the transparency they expect of the funds they rate. This month, PortfolioConstruction Forum asked the research houses: What are the key risks your firm assesses when rating funds/products/capabilities, and why?

Lonsec

The risks that Lonsec considers when researching unlisted investments include:

• Leverage – the differing volatility and liquidity characteristics of the underlying asset classes, since appropriate leverage levels are not standard across asset classes and may change under different market conditions;
• Liquidity – both at portfolio and security specific level;
• Counterparty – this is a risk that may not be adequately rewarded (eg, by a paid premium), but is necessary in functioning asset markets. Lonsec believes it should be fully assessed and diversified by using a number of different and, preferably highly rated, counterparties;
• Concentration – while concentrated portfolios have the potential to generate higher returns, these returns may be more volatile and the portfolio may carry higher degree of factor risk;
• Credit – the credit worthiness of a corporation or corporation’s debt issues;
• Related party exposure – the extent to which a portfolio is used to seed related party interests is a significant risk and can create a potential conflict of interest, particularly where not supported by a strong investment case;
• Currency – Lonsec’s currency risk rating conveys the extent to which capital and income are affected by currency fluctuations;
• Corporate – Lonsec’s corporate risk rating highlights the relative stability of, and level of resources available to, the investment manager (ie, not the result of a full financial due diligence on the financial viability of the manager);
• Capital volatility – takes into consideration the duration, credit, structure, political and other risks of a product’s underlying holdings;
• Income volatility – where a fund objective is to deliver a specified level of income, Lonsec assesses the likelihood of the underlying assets being able to consistently meet that defined level of income; and,
• Third party service providers – particularly important for hedge funds and other non-traditional asset classes where operational risks are deemed to be high. Lonsec assesses the quality of prime brokers, administrators, custodians, auditors and legal functions to ensure they are adequately resourced and experienced to provide such services.

When researching direct property, Lonsec also examines of a number of operational, financial, liquidity and management risk factors relating specifically to the project. As part of Lonsec’s risk assessment, the financial performance of the parent group of the responsible entity/manager is examined. If the manager is part of a group listed on the Australian Securities Exchange, Lonsec will have access to the publicly available financial statements and operational announcements. If the group is a privately owned entity, similar financial information will be requested and taken into consideration (whether supplied or not) in the assessment of whether to approve a project for rating. In addition, Lonsec tracks the performance of all of the manager’s other relevant property or infrastructure funds – firstly, in terms of actual versus forecast distribution, and secondly, total returns versus appropriate benchmark.

Mercer

Mercer uses a four-factor framework to rate managers and funds, including evaluating risk.

• Idea generation – looks for qualitative indications that sustainability of idea generation could be at risk. Assessment areas include size of team versus the investment universe, team dynamic and quality of leadership, and ability to grasp and adapt to changing market dynamics;
• Portfolio construction – risk assessment covers whether a manager is aware of the various over/underweightings in the portfolio and that those positions are intentional, and whether the process highlights to the team when positions are unintentional and a process to deal with this. Quantitatively, portfolio holdings are examined to assess various risk exposures relative to the benchmark, to the manager’s history, and to peers. For bond portfolios, the manager must demonstrate its internal risk tools, and we also assess how the manager uses derivatives, and manages currency and market exposure;
• Implementation – assesses the risk that the manager is losing value when moving from a theoretical portfolio to an actual portfolio through trading; and
• Business management – assesses the risk of any change to management structures and incentive compensation plans that could erode the firm’s standing in the marketplace or its ability to attract talent.

On an ongoing basis, risk is assessed quarterly including the following areas:

• Past (performance analysis) – what has been the performance against objectives and benchmark? What have been the key elements in achieving this performance (ie, detailed attribution analysis)? Is there evidence that the investment approach has changed and if so, how?;
• Present (portfolio analysis) – what is the manager’s current stance, as reflected in their portfolio? Is the portfolio consistent with the identified philosophy and process in terms of risk, style biases, capitalisation, sector and stock themes? Is the portfolio appropriately positioned to be able to meet the performance objective?; and
• Future (potential analysis) – is there any change in the level of confidence in the manager’s ability to achieve the performance objective set? The research process will be looking for triggers such as change in organisational structure or personnel, changes in strategy, performance.

Morningstar

Morningstar did not provide an appropriate response to the question. 

Standard & Poor’s

Standard & Poor’s Fund Services (S&P) considers multiple dimensions of risk when rating funds. These include investment team-related risks (including experience and skill), key person risk, team turnover, and the ramifications of these on the manager’s capability. S&P also assesses whether the team is adequately resourced relative to the demands of its investment process to ensure decisions are supported by a robust and repeatable decision-making framework.

Investment risk exists at the underlying asset class and portfolio-construction levels. Funds are analysed in peer groups based on asset classes to help investors understand the different risk/return characteristics and to compare like with like. S&P considers whether the level of risk being taken is compatible with the returns and investment objectives.

S&P’s process evaluates how fund managers manage risk, their adherence to their internal risk control measures, and whether they can demonstrate a clear understanding of where the portfolio risks lie. Areas assessed include portfolio constraints around asset allocation, securities, sectors, and regions (if applicable) and how these are monitored. In addition, risk analysis covers style biases; portfolio concentration/diversification; use of derivatives; constraints for short selling and leverage; and liquidity, currency and market-specific risks.

An area of focus is the overall risk management capability and whether the manager has quantitative risk systems in place or is solely reliant on qualitative risk assessment. S&P investigates how the systems are used in the investment process. Understanding a portfolio’s risk characteristics allows S&P to gauge the suitability of certain strategies and the underlying investments for particular types of investors (S&P’s fund ratings do not take into account any particular person’s financial or investment objectives, financial situation or needs).

Quantitative analysis helps S&P’s analysts assess whether the manager’s stated investment and risk-management processes are reflected in historical performance. Net performance is evaluated on a risk-adjusted basis relative to benchmark, absolute, and relative to peers. While S&P’s ratings reflect a forward-looking assessment of the manager, S&P assesses the risks the manager has assumed to generate a particular level of past return and whether the past returns achieved are commensurate with the risk level. A variety of statistical ratios over various time periods are used to gain a comprehensive view of the potential risk/reward payoff and whether the manager is staying true to label.

All fund managers rated are required to complete a periodic business sustainability survey. This focuses on financial risk associated with the fund manager, including profitability of the business, corporate structure, compliance, and corporate governance and business strategy. This survey helps S&P assess the probability of the manager remaining viable, particularly if it is not yet profitable.

Finally, S&P’s analysts also explore operational risk factors, particularly in the alternatives sector where many boutique firms undertake complex investment and trading strategies, and are exposed to counterparty and custody risks. Corporate structure, governance, and compliance practices are key to ensuring appropriate segregation of duties, and policies should be in place to reduce the potential risk of loss resulting from inadequate or failed internal processes, systems, human factors, or external events.

Van Eyk

Van Eyk’s research process takes into account many different types of risk.

Firstly, van Eyk’s risk ratings give a better sense of investment risk in itself, highlighting the uncertainty of investment outcome and the potential risk of loss of investment principal. For risk ratings, both market risk and strategy risk are classified from high to low. Market risk, or beta, is common to active and passive strategies investing in the same asset sector or sub-asset sector. Strategy risk, or alpha, is the risk resulting from active investment management. Both types of risk ratings together give a sense of how a strategy might perform in variable financial environments. 

Our second view of risk is in comparison with a strategy’s investment potential. This focuses on the risk-return trade off that a fund presents relative to its peers, and – all else being equal, including van Eyk’s view of risk – higher ratings tend to be given to strategies that van Eyk’s analysts believe will be able to generate relatively high returns with less risk. In fact, the traditional measures we use to rate active managers – people, process and business management – each contain elements of this risk-return trade off, even though they may not be quantifiable. For example: is an investment team unmotivated or unstable? Is an investment process too rigid or mechanical? Does a strategy’s fee hinge on a benchmark that does not match its investment objective? These are all examples of risk that could be assessed by an analyst and potentially form part of a strategy’s overall rating.

Van Eyk also uses quantitative measures to analyse all managers. These include a strategy’s excess returns over time, the volatility of returns and excess returns, and a strategy’s performance in both up and down markets.

We also look at how an equity strategy’s performance has varied over time, including how a strategy’s style (in its actual portfolio holdings) compares with how the manager has described itself. We view a significant difference between the two as a potential investment risk, and would be inclined to seek more information from the manager to explain the difference.

For fixed income strategies, we consider a strategy’s risk-return trade off compared with its peers, analysing all of the applicable performance and style attributes we use for equities, as well as measures that are specific to this type of manager, including duration, credit and sector risk, among others.

Finally, for alternative strategies, which encompass equity, fixed income, currency and other markets, we use a number of measures specific to each. 

Exchange-traded funds (ETFs) have an entirely different set of identified risks. We look at factors that would affect an investors’ result, including the liquidity risk of the underlying securities in the ETF, as well as primary and secondary market liquidity in the ETF itself. 

Zenith Investment Partners

Zenith reviews a wide range of factors when assessing the risks of a fund/product, grouped into two broad categories.

Qualitative risk factors

• Investment personnel – the assessment of the investment team responsible for the management of the fund/product is the most important factor in assessing the risks of a fund/product and carries the highest weighting in our risk assessment process. The risk factors assessed here include the experience, qualifications and structure of the investment team (including key person risk). An assessment needs to be made of the reliance on the individuals within the investment team and what impact this would have on the management of the fund/product if the key person/people were to leave. This consideration has become much more of an issue with the emergence of many more boutique fund managers over the past six to seven years.
• Investment process – the investment process applied in the management of the fund/product is also assessed for risk. That is, is the process well articulated, transparent and understood by all members of the investment team or reliant on the subjective judgment and decision-making of a single portfolio manager? If it is the latter, this would be considered higher risk than a well articulated process applied by multiple experienced people that could be continued even in the event of a key person departure (eg, Perpetual Australian Equities Team). The manager’s investment style is also assessed as a risk factor as very specialised and/or extreme investment styles can be out of favour for long periods of time and as a result can lead to extended periods of underperformance.
• Organisational structure and stability – with the emergence of the plethora of boutique investment managers over recent times, assessment of a manager’s business and ownership structure has become increasingly important. Aspects such as balance sheet strength, profitability adequate working capital, and fund size and funds under management are all key risk factors assessed. From this perspective, managers that display low levels of working capital, poor profitability and low levels of funds under management are considered high risk and would not achieve strong ratings. In addition, complex and/or non-transparent ownership and shareholder structures are also considered high risk, as this can lead to corporate instability.
• Portfolio construction and management – the assessment of portfolio construction guidelines and constraints for a fund/product is a major contributor to the assessment of a fund/product’s risks as this provides an insight into the likely diversification or concentration of the portfolio holdings including maximum stock weighting; maximum ownership of a security (by market cap); maximum sector weight; maximum country/region weight; and, required security liquidity.

Quantitative risk factors

From a quantitative perspective the key risk factors assessed include volatility and downside deviation, and consistency of returns. Volatility (as measured by standard deviation) and downside deviation are much more important measures of risk than measures such as beta and tracking error because loss of capital is much more important to investors than deviation from a benchmark. Consistency of returns is also an important measure of risk because, when rating a fund/product, the more consistent its return profile, the more similar different investor’s return experience will be.