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WF: In asset management, nothing is more crucial than managing risks. What are the risks generic to mutual funds and how do AMCs work to mitigate it?
Amit: While the asset management industry is exposed to several risks-each critical-none is greater than the risk of loss of reputation. For any asset management company (AMC), investing people's money is a matter of building a track record of good investment practices, careful selection of investments in quality assets while optimizing the returns generated. It is very crucial, therefore, that the AMC has strong risk management practices.
AMCs strive to analyse all types of risks-credit, market, operational, liquidity, regulatory, and so on. Credit risk is the risk of a decline in creditworthiness of the borrower. Market risk is the change in prices including interest rate and currency risks; operational risk is the loss due to a failure in systems and processes; liquidity risk is the lack of saleability of an asset; regulatory risk the change in regulations affecting a stock, sector or fund.
In general, large AMCs have a dedicated team of risk managers, who oversee the portfolio risk. They are independent of the investment teams and help in evaluation of the portfolio against risk parameters. It is apt to mention here that, we can only mutate the nature of risks, and cannot entirely get rid of a risk without giving rise to another type of risk. The key, however, is to assume risk which we understand and are comfortable with.
In terms of generic risks, all funds, equity or debt, are exposed to redemption risk. Funds may be suddenly faced with severe redemption pressure, as was evident during global financial crisis of 2008. During such an eventuality, a fund may then have to liquidate its investments at distress prices. Funds manage redemption risk by monitoring redemption requests and holding adequate liquidity. Funds also tend to impose exit load to mitigate the impact of redemption prior to the stipulated period (while preserving the investor's right to redeem).
Another challenge faced by AMCs is to understand investor's return expectation and risk tolerances. Therefore, it is important to map the suitability and appropriateness of the product with investors' needs.
WF: In equity investments, a significant risk for investors is the permanent loss of capital. How does an AMC manage the risks specific to Equity Funds?
Amit: In market parlance, risk is measured by volatility, that is, the change in price of an asset. The bigger the movement in the prices, the greater is the risk. The investment risk of a portfolio is also driven by the mandate of a fund-the nature or type of assets it invests in.
While there is no concept of default risk in case of equity funds, they are exposed to other risks. The key risks include- (I) fund structure risk (open-ended funds would inherently have higher sensitivity to redemption pressure), (II) fund capacity risk (evaluating investment opportunities in relation to the market volume, particularly in thematic and sectoral funds); and (III) correlation risk (how an asset price moves against another investment. A negative correlation may eat into the fund's value, while a highly correlated portfolio may not entirely reflect diversification benefits).
To manage risk, one has to measure it. The problem is that while some are easily measurable, some are not. Holistically, while volatility risk can be measured; often event-related ones cannot be.
As part of risk measurement, AMCs endeavour to forecast the future state of variables. Tools such as stress testing a portfolio and scenario analysis are regularly used to assess the potential impact on a portfolio in times of extreme volatility.
When managing investment risks pertaining to equity funds, it is important to define an investment universe and keep track of it. A robust research function plays a key role in this case. Investment risk is also typically addressed by stipulating limits on exposure to sectors, stocks or issuer. Thus, funds endeavor to restrict the exposure levels below these thresholds. Further, it is important to analyse how the performance of a fund has been generated on the basis of qualitative and quantitative metrics.
WF: How does an AMC manage the risks specific to Debt Funds?
Amit: Debt funds are exposed to interest rate risk. Interest rates being inversely related to bond prices, increase in interest rate increases, make the existing bonds less attractive and cheaper, resulting in a fall in the value of debt fund investments.
Risk managers keep a regular tab on key macroeconomic variables, e.g., money supply, inflation, movement in foreign exchange rates, current account deficit and event risks that can have a bearing on a fund.
Counter-party credit risk is another risk to consider, but it is relatively lower in case of funds which primarily invest in extremely liquid money market instruments and government securities. Compared with debt funds, credit funds could have a relatively higher counter-party credit risk. Within credit risk are two components- default risk & migration risk. While default risk is borrower's inability to service the debt, migration risk refers to worsening in the creditworthiness of issuer.
The credit funds tend to address counter-party credit risk through proper client selection, adequate security and tighter monitoring. The client selection should be based on the 4Cs of Credit- character, cash flow, capital (resources), & collateral. It is essential to conduct independent review of credits prior to on-boarding independent of investment team.
One cannot solely rely on external ratings, and it can be one of the filters while analyzing an investment. A robust due diligence is required to evaluate a borrower's ability and willingness to service debt. Credit due diligence should include identification of the sources of repayment, financial analysis- with a focus on cash flow analysis, discussion around key risks and mitigants, and terms & conditions.
Concentration risk and maturity are also important aspects to analyze. One has to build a structured process around asset selection exercise and avoid concentration risk by adhering to the investment limits and tenor restrictions approved in case of each issuer.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
All data/information used in the preparation of this material is specific to a time and may or may not be relevant in future post issuance of this material. ICICI Prudential Asset Management Company Limited (the AMC) takes no responsibility of updating any data/information in this material from time to time. The AMC (including its affiliates), ICICI Prudential Mutual Fund (the Fund), ICICI Prudential Trust Limited (the Trust) and any of its officers, directors, personnel and employees, shall not liable for any loss, damage of any nature, including but not limited to direct, indirect, punitive, special, exemplary, consequential, as also any loss of profit in any way arising from the use of this material in any manner. Nothing contained in this document shall be construed to be an investment advise or an assurance of the benefits of investing in the any of the Schemes of the Fund. Sectors/stocks mentioned in the article do not constitute any recommendation and the Fund through its schemes may or may not have any future position in these sectors/stocks. Recipient alone shall be fully responsible for any decision taken on the basis of this document.
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