Asset managers are facing a catch-22. More frequent and larger risk volatility shocks are on the cards. At the same time, restricted budgets and resources mean they aren’t getting a clear understanding of scenario analysis for reliable risk forecasting .
A recent survey conducted by the Economist Intelligence Unit found that a significant number of organisations don’t have the business models or a strategy in place to cope with these unexpected levels of volatility. In fact, nearly a third of the respondents
said they don’t have a system in place to shield their clients to this risk.
But tackling this isn’t impossible – asset managers need the right tools in place to provide a holistic view of risk. In my opinion, the best practice approach is to develop a more robust scenario analysis framework alongside conventional risk reporting.
Start by reviewing a range of historical scenario shocks which have impacted the markets recently to discover how correlations change during such crises. Then create plausible forward-looking scenarios for potential shocks (such as the break-up of the euro-zone
or an Iranian oil shock). The most useful scenario tool for fund managers is reverse stress testing – asking the question “what could hurt me the most?”
The way I see it, creating a risk mitigation culture is similar to testing a brand new car design. When a new model is being tested it doesn’t just go through one simple head-on crash test but a series of tests across all angles of impact to ensure better
protection for the driver and passengers. Asset managers need these kinds of tests in place to be able to think imaginatively about what can hurt their performance.
Asset managers need to focus beyond the screens in front of them. The challenge they face is to be able to open up to more sources of information about systematic or macro risks. With an industry facing very low returns on risk-free assets and increasing
chances of volatility shocks, we must make use of more sophisticated scenario analysis methods in order to achieve more robust asset allocations.