Showing posts with label funds. Show all posts
Showing posts with label funds. Show all posts

Mar 17, 2013

AIFMD Fun of Funds

To prevent future crises, a new European law, the Alternative Investment Fund Managers Directive (AIFMD)  came into force on 22 July 2011.

The new directive has to be implemented before 22 July 2013 and will also apply to non-EU fund managers if they ares managing or marketing an AIF to investors in the EU.

It is believed that the directive will reduce the number of non-EU managers operating within the EU.

AIF's assets and risk management
Although the AIFM-Directive has many new demands (appoint independent valuer, custodian, disclosure) we'll focus here on the requirement to ensure an independent evaluation of the AIF's assets and risk management.

AIFMD Risk Management Obligations
  • Every AIFM needs to have an adequate documented risk management policy, covering all possible risks faced by the AIFs
  • Every AIFM has to set quantitative and qualitative risk limits for each AIF for all possible kind of risks 
  • An AIFM's Risk Measurement Procedure should include requirements for: backtesting, stress-testing, scenario analyses and the rules should describe remedial action plans when limits are breached. 

So far so good, peace of a cake, you would think. Unfortunately: NO!

1. In-depth market risk assessment: too complex and not adequate
An adequate in-depth market risk assessment of AIFMs AIFs actually requires a full 'fund of funds' transparency of the portfolio of the (AIF) funds.

The problem is that full 'fund of funds' transparency does not exist yet, nor can it finally be fully obtained. It's simply too complex:
  • undefined systemic risks are often beneath the analyse surface
  • (re)hedged risks could be part of a fatal unknown or unapparent self-reference hedge cycle
  • in-depth 'fund of funds' management is time consuming and presumes that risk profiles of sub-funds are available, when in practice they are often not

To illustrate the desperate, funny and useless efforts that are made to tame the 'fund of funds' issues within the AIFMD, just take a look at the next quote from the AIF Handbook draft 2013 :

Section 5-iii-1, Alias 'Fun' of Funds
"Any proposed investment by a Qualifying Investor AIF into another investment fund must be clearly disclosed.
Disclosure must focus on the implications of this policy regarding 
increased costs to unitholders (i.e. the fact that fees will arise at two or, in the cases where the underlying fund it itself a fund of funds, three levels – the Qualifying Investor AIF, the underlying fund of funds and the underlying funds in which the underlying fund of funds invests) and the resultant lack of transparency in investments."

I hope you're still with me after all this fund of funds of funds of funds fun..... ;-)

Thus, in-depth market risk assessments in a non transparent market are inadequate and may potentially result in ill-founded or even erroneous conclusions (e.g.' false safety').

Market Risk Assessment
The adequacy of an AIFMD's Market Risk Assessment could be roughly defined as:

MRA-Adequacy = ADTQ x RPQ x RMQ

With: ADTQ= Asset Data Transparency Quality, RPQ= Risk Policy Quality and RMQ = Risk Model Quality.

Just let your colleague rate your ADTQ, RPQ and RMQ on a ten point scale. If the outcome MRA-Adequacy is lower than 800, consider your test as inadequate.

As transparency also includes full sub-cycle  'fund of funds' transparency, often ADTQ will not score high enough for an adequate test outcome.

Suppose an AIF consists of 30% 'fund of funds' with minor risk information regarding the sub-funds.All other scores of the AIF score well (10). In this case the test adequacy score is 700 (= 7 x 10 x 10) . Conclusion: the quality of your risk assessment is insufficient for drawing robust conclusions.

2. Alternative: Strategic Market Risk Assessment
Instead of - come what may - trying to get to the endless bottom of a 'fund to fund' construction, a more strategic risk assessment approach -  as an alternative -could work out much more effective. A strategic market risk assessment that assesses the nature, risk and policy of a AIF and its investments and that implicitly takes into account non-linear risks, the presence of systemic risk, a large number of weighted and not-weighted economic scenarios, stress tests and fat tail risks.

The Secret of the Chef
Many (hedge) funds have only a limited transparent investment policy or an investment policy that  - for whatever reason -is regarded as 'The Secret of the Chef'.

In these kind of funds 'full disclosure' will end in a lot of degrees of freedom in 'risk policy' and corresponding mandates.

It's important to realize that the more degrees of  freedom in 'risk policy' a manager of a fund has, the more risk will emerge in the above formulated alternative assessment.

New alternative market risk models?
Key question is: are there new models that can assess investment strategies and portfolios in a systemic risk environment and on basis of non-linear modeling.

The answer to this question is : Yes, very soon!

Symetrics, a brand new company in the Netherlands is developing an investment decision support and assessment system called SyMath, that is based on nonlinear modeling, grasps systemic risk and includes future crises. SyMath will be on the market mid 2013.

Until then will have to assess AIFMs with pen and pencil... ;-)

Links, Used Sources

Aug 7, 2008

Origin of funds?

What's the origin of (mutual) funds?

In 1774 a Dutch merchant Adriaan van Ketwich started an investment trust under the name "Eendragt Maakt Magt" (translated: Unity Creates Strength).
Five years later Van Ketwich starts his second trust under the name 'Concordia Res Parvae Crescunt' (translated: Small things grow in harmony).

If you're interested: Geert Rouwenhorst did a lot of historic research in 'the origins of mutual funds'.