A Note on Risk

mousetrapI heard a quote from Howard Marks at Oaktree, who was explaining that managing risk should not be left to designated risk managers: “The bottom line for me is that risk management should be the responsibility of every participant in the investment process, applying experience, judgment and knowledge of the underlying investments.” We love our risk guy – he is a critical part of our team, but I like to think that this diverse approach applies to our firm as well. Everyone in the firm, and clients who want to, have access to our risk analytics. We are all thinking about the elements of the portfolio, how they interact and the relationships we may have overlooked. We also look for trends about how others think about risk. What follows are a few observations:

• Risk aversion is up, in my opinion because lives are being lived at lower risk. When I tell people I work at a hedge fund, they invariably ask – isn’t that risky? NO, it’s a nice life. Do the honorable thing, treat your clients, counterparties and co-workers with respect, be diligent, creative and committed and things will work out. I am composing these notes on June 6, the anniversary of the D-Day invasion. Heading across the English Channel, in a less than seaworthy craft, shells exploding all around, waiting for the ramp to fall and expose you to sea and shore – that’s risk.

• The concept of risk has become too academic. If we just create enough tables of numbers, we think we can control it. In our view the academic side of risk measurement is substantially junior to several straightforward pragmatic questions – are your instruments liquid, do you have good pricing, do you have cash on your books, and, importantly, how dependent are you on people outside your firm – counterparties and the like. Sure, look at VAR or Monte Carlo simulations or whatever, but chances are real risk lies in the answer to the simple questions.

Convergence of consensus – this is the big systemic risk, in our view. It’s hard to measure, it’s binomial in distribution, and it’s pathological. Prime examples – the Swiss and the Bund. No amount of VAR is going to capture this risk. Lesson – don’t write free options.

• Our financial leaders have the yips (mental incapacity to putt a golf ball or throw a baseball). In a speech a few years ago, I heard Paul Volcker say that the Fed resembles the faculty lounge. This was not a compliment. It seems to us that the Fed is terrified of a 10% correction in the stock market. They refuse to acknowledge that data has improved a lot. Perhaps they missed the behavioral economics seminar, but if they keep saying the economy stinks, people will believe them and hold back.

The crash of 2008 was bad – as bad as it gets in the financial markets, but perhaps we should have more faith in the system.

-Tim Rudderow, CEO & CIO