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com

Fine tuning
Daniel Broby sees the relationship between the investment and performance teams as
being as integral to each other as the workings of a well designed racing car. Here he
outlines how best these teams might interrelate

T
he investment team is often
seen as the engine of fund
management performance
and the performance team
as the instrument panel. The
latter complete with speedometer, fuel
gauge, temperature and RPM counter.
It is easy to fall into the trap of
believing the engine can win the race
without such bells and whistles. If they
are really unnecessary, none of the
latter would be included in a Formula 1
car. Likewise, in order to win at fund
management, performance
measurement is equally necessary. The
best fund managers, as a result, use
performance teams to provide insights
as well as measurement and attribution.
Considering this important insight,
the topic of what investment teams
need from performance teams is
insufficiently addressed. The seamless
integration between the middle office
and the rest of the firm is just part of
the story. This integration should be
combined with useful interaction and all
too often this element is missing.
The other thing to take into account
in discussing the role of performance
teams in a fund management

6 PMCRR I Autumn Volume 3 Issue 1


organisation is that the investment
world has entered a new return
paradigm. Correlations have proved
higher than history would have
suggested and volatility appears to
have structurally changed. Clearly the
environment we find ourselves in
requires more internal support for
the investment processes and a
higher profile role for performance and
risk teams.
I believe it is now incumbent on
portfolio managers to know when
positive alpha morphs into beta on the
downside. Performance measurement
and attribution provide the statistical
tools to help flag when this might be
happening. Performance teams should
be structured to track such dynamic
changes in the marketplace, not just
calculate total and relative returns for
reporting purposes. In this respect, as a
bare minimum, they should monitor:
➜➜ changes to overall portfolio risk;
➜➜ increases/decreases in sector
biases;
➜➜ increases/decreases to factor
exposures;
➜➜ reviews of risk and concentration
limits; and
➜➜ where the portfolios conform
to strategy objectives and the
macro view.
The goal is to ensure that portfolios
are managed according to guidelines
and are consistent with the clients’ risk
appetite and tolerance. The ability of
the performance team to monitor rapid
changes in risk is another main
component of this area. Hedging and
overlays can then be used by the
investment team to respond to changes
in the investment environment.
In order to make any interaction
work in practice, it is important for the
performance team to maintain a robust
database. In the racing car analogy, this
is equivalent to having an on-board
computer. The minimum systems
should include:
➜➜ the ability to monitor hard/soft
limits on certain sources of risk
PMCRR I Autumn Volume 3 Issue 1
(ie, concentration limits such as
sector limits and asset class risk
budget allocation limits);
➜➜ the ability to produce exposure,
contribution and attribution
reports;
➜➜ the ability to produce risk reports,
including tracking error,
diversification of the portfolio and
portfolio characteristics;
➜➜ the absolute oversight of risk and/
or tracking error targets or limits;
➜➜ position reporting;
➜➜ risk management systems,
typically factor-based; and
➜➜ systems that oversee the use
of leverage.
The nature of the interaction
between investment and performance
teams also depends on whether an
absolute or relative return approach is
taken. Indeed, this aspect also impacts
the reporting function and the way a
performance team interrelates with
clients. In effect, the performance team
should help the clients understand
what they are being charged for
(hopefully risk adjusted out-
performance). This is where the
performance team can add strategic
value to an organisation.
The distinction between
benchmarks and indexes has been
illustrated in the book A Guide to Equity
Index Construction, in addition to the
trade-off between breadth and
inevitability, rebalancing versus costs,
and rules versus value judgements. I
believe these are all areas where
investment teams can benefit from
input from the performance team.
In this new post-credit crisis world
in which we live, I cannot fail to
mention the role of performance teams
in risk measurement and assessment.
Indeed, portfolio risk control is central
to the middle office function.
Throughout my career, I have noticed
that the investment process is
increasingly embracing risk as both
integral and iterative to its success. It is
now common for the performance and
I interdepartment relations
risk teams to meet with the portfolio
managers and discuss the various
issues. Initially, this was driven by the
desire to answer investment
consultants but increasingly it is being
driven forward by the desire to
understand ever more complex markets
and financial instruments. With the
continued presence of hedge funds,
shorting and leverage, this will
continue. The next step, as a result of
this, will be for new risk measures.
VaR (for more on VaR see page 31),
tracking error and factor models have
all proved themselves lacking in some
vital respects. It is incumbent on the
performance team — not the
investment team — to introduce
these measures.
Although new priorities and
challenges can sound daunting, I
believe fund managers gain a
competitive edge by having a fully
integrated risk, performance and
investment team. To achieve this, the
middle office portfolio risk control
should be designed for:
➜➜ accommodating changes in
investment philosophy or process;
➜➜ capturing securities held outside of
mandate;
➜➜ compliance or regulatory issues;
➜➜ counterparty and liquidity
management;
➜➜ delivering qualitative, forward-
looking risk assessments;
➜➜ identifying the underlying drivers of
risk and return across asset
classes and complementing
quantitative risk measures;
➜➜ measuring manager turnover;
➜➜ stress testing and extreme risk
measurement capabilities;
➜➜ detecting deterioration in
performance;
➜➜ detecting style drifts; and
➜➜ transparency.
Performance success is aided by
beating the competition and, as such,
the performance team is often charged
with monitoring competitor funds.
Indeed, the comparison of fund returns
7
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There will, however, always be conflicting forces between impartiality and the demands
from marketing
with a competitor’s is the most
common method of evaluating fund
performance at the firm level. As part of
this function, feedback should be
passed on by the performance team to
the investment team on competitors’
positioning and their largest holdings.
It is always good, as Sun Tzu
observed in The Art of War, to know
your competitors.
There will, however, always be
conflicting forces between impartiality
and the demands from marketing.
Fortunately, we now have the CFA
Institute supported GIPS (Global
Investment Performance Standards).
These standards provide an institutional
framework on which the performance
team can build a professional offering.
In structuring the middle office,
senior management should understand
8 PMCRR I Autumn Volume 3 Issue 1
that risk and performance techniques
are often seen as complex and black
box in structure. The output of
performance teams can be difficult to
interpret and communicate to
investment teams. The role played by
the Professional Risk Managers’
International Association (PRMIA) in this
respect is important. PRMIA raises the
professionalism of the performance and
risk profession. Indeed, any
professional qualification, such as the
Certificate in Investment Performance
Measurement (CIPM), makes for better
interaction between the performance
and the investment team.
Any well-built racing machine needs
precision to win the race. This precision
is what a well structured performance
team brings to a well structured
investment team. There are a number
of internal processes that can be
applied to ensure the systems and
controls are both up to the job. They
include analysis of data, the risk
management function, an integration of
qualitative judgment with quantitative
analytics, an assessment of liquidity
and counterparty risks and enhanced
risk analytics, including stress testing,
factor analysis, tail risk and multiple-
horizon modelling. In this respect, I look
forward to the day when performance
teams and investment teams are as
seamlessly integrated as the workings
of a well built racing car.
I PMCRR
Further reading
Broby, DP. A Guide to Fund Management. Risk Books
(2010); ISBN-13: 978-1-906348-18-2
Broby, DP. A Guide to Equity Index Construction. Risk
Books (2007); ISBN-13: 978-1-904339-77-9