5 risk management questions you must ask every fund house

Robbert Vonk - CFO & COO and S S Ramaraj, Head - Risk Management, Canara Robeco MF

Risk management often does not get the level of advisor mindshare it deserves - and only comes to the fore amidst unfortunate events. In that context, we asked two experienced risk veterans from Canara Robeco, 5 questions which we believe every IFAs should ask every fund house. Their rich insights and the processes they have adopted offer valuable insights into what risk management is really all about. Avoiding accidents is perhaps as important as the quest for alpha and it is a judicious combination of both that really helps fund houses deliver predictable and consistent returns over the long term.

WF: 1. Liquidity risk in credit funds: Given the huge growth in this segment, the liquidity mismatch between what the funds promise and that of the underlying portfolios is also a growing concern. How do you manage liquidity risk in this growing category and how should advisors try to understand the extent of liquidity risk in different funds?

Robbert and Ramaraj: Liquidity in the fixed income markets globally has been negatively affected ever since the global financial crisis of 2008. The problem is exacerbated because all the asset managers allow clients the freedom to trade into funds on a daily basis. This gives investors the confidence that they can always get their money back - or quickly top up investments should they wish. But it leaves asset managers vulnerable to a sudden exodus if a market turns unexpectedly. Canara Robeco has its own measures to ensure the stability of its range of fixed income funds. There are several safeguards: firstly, through proper risk measurement and secondly, through risk mitigation:

Canara Robeco has a comprehensive liquidity risk framework incorporating the dynamic that exists between liquidity risks related to assets on the one hand and funding on the other. Asset liquidity risk arises when transactions cannot be conducted at quoted market prices due to the size of the required trade, or, worse, when they cannot be conducted at all. Canara Robeco's risk policy focusses on verifying whether the current portfolio is liquid enough to meet substantial future redemptions. If not, the portfolio will explicitly be discussed in the Risk Management Committee (RMC) and measures will be taken.

Additionally, exposure to illiquid instruments is restricted at portfolio level which makes us less dependent upon the RBI to come out with contingency plan (like it did in 2013) during severe liquidity crises, either as a consequence of severe cash outflows or unusual market distress.

We also have strict rules to make sure we have sufficient liquid buffers. For instance, a substantial percentage of the funds is held in in cash equivalents like traded government securities and actively traded bonds / debentures. Canara Robeco has also ensured that, if necessary, funds have the ability to temporarily run a deficit.

Last but not least, Canara Robeco takes a relatively conservative stance when it comes to investing in credits. This is a conscious decision made by Canara Robeco to avoid unnecessary negative surprises or the client on the liquidity and market risk side.

WF: 2. Liquidity risk in mid and small cap funds: Similar issues - growing fund categories and a history of liquidity in smaller names evaporating during market downturns. How do you manage liquidity risk in your mid and small cap oriented funds?

Robbert and Ramaraj: Canara Robeco's liquidity risk framework incorporates the dynamic that exists between the asset and funding liquidity risks. The policy focusses on verifying whether the current portfolio is liquid enough to meet future redemptions and to ensure the efficient execution of the fund's strategy. If not, the portfolio will explicitly be discussed in the RMC and measures will be taken if required.

Specifically for mid and small cap positions we have placed limits on the maximum quantity that can be invested in scrips based on the 3 month traded volume of the holdings in the portfolio. In case a scrip's holding in the portfolio exceeds a predefined multiple of its 3 months average traded volume, fresh purchases in that scrip are prohibited by the system. We have also placed hard limits on exposure to ultra small cap securities. In addition, Canara Robeco analyses the liquidity risk development of a portfolio on a monthly basis and also conduct scenario analysis.

Even during good market conditions, limits are imposed on the Fund Manager based on volume. For equity investments active bet limit is applied at both scrip level & sector level (within limits specified by SEBI). Breaches if any, need to be regularised within stipulated time. This ensures that the fund manager takes out part of the profit from the table regularly

The combination of these measures help ensure Canara Robeco that its clients are not faced with avoidable liquidity issues on the equity side.

WF: 3. Credit risk: In recent times, we have seen defaults and downgrades impacting credit funds. Given the scepticism around published credit ratings in recent times, what independent processes do you adopt to manage credit risk? How should advisors discern credit risk in an environment where they are wary of relying completely on published credit ratings?

Robbert and Ramaraj: Recent crisis across the globe have made clear that relying on ratings alone is a recipe for disaster. There is an apparent lag in the signalling function ratings provide, in addition, the financial sectors blindly following ratings can augment systemic risk. Therefore Canara Robeco has developed an elaborate credit risk framework to set credit limits. Here, ratings are only one of the 7 different financial parameters that Canara Robeco considers for fixing the exposure limit for an issuer. We have different models for assessing NBFCs, Banks and other companies. Canara Robeco has a team of dedicated credit analysts who independently scrutinize the companies positions on both hard and soft indicators and place the names to our RMC for approval. The exposure limits are fixed by RMC by taking in to account the financial position of the issuer , the sectoral outlook as well as its promoters in addition to the valuation model.

WF: 4. Valuation risk: How comfortable are you about valuation guidelines in our industry allowing for a fair representation of realizable market value of assets in mutual funds? Where, if any, are some areas for improvement in this context?

Robbert and Ramaraj: The impact cost on buying and selling of scrips / securities on the portfolio's NAV can lead to under / over valuation of the portfolio. The responsibility of protecting continuing / existing investor's interests in case of abnormal redemption / investment falls on the fund manager and to an extent the fund manager times the market which adds further volatility risk.

However, the current valuation policy, that is almost uniform across different houses, ensures that the performance comparison based on NAV movement is consistent and this is the best that one can hope for in a volatile market.

There is a way to manage the valuation risk by using "SWING" pricing. A concept followed globally where the impact and other costs of creating liquidity in case of redemption and the impact and other costs of buying in case of investment will be borne only by the exiting investors(in case of sale) and entering investors(in case of purchase). However, moving to such a model would require an industry consensus and investor education.

WF: 5. Positioning risk: Purists would like every fund to scrupulously adhere to the rigid confines of a clear fund positioning and mandate while market forces sometimes influence fund managers to give themselves some leeway in a bid to enhance performance - which at the end of the day should benefit investors. Where should risk management draw a line in this context and how do you manage this risk at Canara Robeco?

Robbert and Ramaraj: At Canara Robeco we are of the opinion that it is of pivotal importance that the client gets what he has been sold. To this end this we always ensure the simple paradigm "we do what we say that we do". Since higher returns are generally accompanied by higher risks, to be able to clearly translate the nature of the product to the clients we find it important to specifically state a risk appetite for each fund.

This risk appetite is translated into a Limit and Control Structures (LCSs), this LCS comprises of internal and external guidelines, all are coded into the risk and compliance systems. Managing the portfolio within the context of the risk appetite is the responsibility of the portfolio managers. Risk Management and Compliance monitor and report on adherence and breaches are resolved within a pre-agreed time frame. When clear necessity or market opportunities arise that conflict with internal guidelines, exceptions can be allowed by the RMC, but only as long as there is clear benefit to the client and we do not unduly adjust the risk appetite, to ensure we always maintain the alignment with client expectations.

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