On a tactical basis, the asset manager can compare the active manager’s actual performance to the passive index’s return distribution to insure that the active manager continues to deliver the performance for which it is being compensated. In the example below, the active manager consistently delivers returns in the +1 standard deviation range and has avoided any significant drawdown. The level of consistency in the active manager’s performance results in superior annualized cumulative returns, validating the results the active manager promised.
The 2008 Financial Crisis and the “London Whale” incident indicate that regulatory financial institutions are not getting what they paid for from their risk management functions. This failure is largely a reflection of the perception that risk management is a control function more focused minimizing regulatory capital than providing investment value. This perspective is unfortunate and need not be the case. The analytical framework and infrastructure necessary to satisfy regulatory requirements also can be used to improve the investment decisions at no additional cost.
Active managers, such as hedge funds, are increasingly being required by institutional investors like asset managers/pension plan to report VaR and other risk management statistics in order to obtain institutional funding. The cost of build out an internal risk management function or using an external risk management advisory can be a significant expenditure. Active managers are well advised to not consider these expenditures as simply a cost of doing business, but are better served by integrating risk management into their investment process.