Investment companies face a unique challenge in risk management. Unlike most firms, they must simultaneously manage two interconnected types of risk: the risks of the managed assets, which are primarily borne by investors, and the risks of the company itself. Although direct losses from investment risks are borne by clients, such losses can have significant secondary impacts on the stability and viability of the investment company itself. History demonstrates how closely these risks are linked.
In 2007, two hedge funds within the Bear Stearns group collapsed. These funds had heavily invested in structured bonds tied to mortgages. When the value of the underlying assets began to decline (regardless of whether we classify the event as market risk or credit), the funds suffered losses. The situation was further exacerbated by high leverage. One of the consequences was damage to the reputation of the fund manager, and ultimately, this chain of events contributed to the downfall of the entire Bear Stearns investment bank.
In the "calm" year of 2019, one of the biggest collapses in the British investment industry occurred. The Woodford Equity Income Fund, which managed assets worth billions of pounds, ran into serious trouble. What happened?
Fund manager Neil Woodford, who had previously achieved above-average returns, gradually shifted the fund’s strategy from investing in large, established companies to focusing on small and unlisted stocks. However, this bet did not pay off, and the fund’s value began to decline compared to benchmarks. At the same time (as later investigations revealed), the fund mismanaged its liquidity. The situation escalated when one of the largest investors requested a withdrawal of £263 million, which led to the suspension of fund unit redemptions. This, in turn, resulted in significant losses for investors and effectively led to the closure of the investment company.
Despite the simplified descriptions of the above cases, both examples illustrate how a series of individual steps can lead to a spiral of problems that result in significant losses for investors and, ultimately, the cessation of the investment company's operations.
These cases clearly highlight the critical importance of a systematic approach to risk management for both investment companies and the assets they manage. Special attention should be paid to leverage (where part of the investments is financed by debt) and concentration risk - when too large a portion of a portfolio depends on the performance of a single asset type or market. Both leverage and high concentration increase risk - potential gains rise, but so do potential losses. Moreover, these risks are difficult to measure and are not always fully visible. (A Czech example could be a real estate fund that holds shares in an SPV owning a commercial real estate property, which is partly financed by a loan.)
Successful risk management requires a comprehensive approach. This includes assessing both managed asset risks and company risks, while recognizing their interconnections. A robust system of controls and limits, which is regularly reviewed and updated, plays a key role. Equally important is open communication with investors.
Advanced Risk Management helps clients - including investment companies - implement these insights into practice. Our services include setting up strong risk management systems, developing both statistical and expert models for risk measurement, and performing independent risk management process evaluations.