The everyday task of turning a healthy profit in the asset management industry is proving increasingly difficult, as regulatory pressures have impacted an industry already impeded by the many reputational knocks stemming from the financial crisis. Today, only the most enterprising of firms enjoy financial stability, with the principle differentiator between success and failure being an understanding of risk and the ways in which it should be managed.

“I think that the business – if you will – of financial services is in itself risk taking, so risk management is naturally very important,” says Kalle Saariaho, Head of Risk Management at Pohjola Asset Management. “The failures we saw during the financial crisis, they were not all necessarily failures of risk management, but of the trust between company and customers.”

Public confidence in financial services is low, and many demand that more must be done to rekindle the love lost between customer and company if firms are to instil any meaningful sense of trust. “That loss of trust was linked to customers not really knowing the exposure of firms to risk, as well as not trusting that the firms themselves knew their exposure,” says Saariaho. “I really think good risk management should help in both decision-making at the firms and also in building trust towards those firms.”

Jumping through hoops
What’s more, the financial landscape has taken an extraordinary turn for the worse, and today firms must jump through more hoops than in pre-crisis times if they are to negotiate all manner of complex instruments and regulatory challenges. Change has been constant, and demand unerring, as the prospect of profitability is no longer the near guarantee it once was and short-termism a sure-fire route to failure.

The circumstances have called for more adaptive approaches from asset managers, and firms diversify their dealings beyond what they once did. “I think that the situation with regard to risk-taking is actually quite similar to that of pre-crisis, in that many investors are forced to chase risk, given that traditional portfolios really aren’t providing enough returns to fulfil their returns objectives,” says Saariaho. “I think when risk premiums go down, there’s a tendency to add risk, but now we at least hope that risks are better understood and managed.”

The loss of trust that has come through irresponsible risk-taking has, if nothing else, served as a lesson in how best to analyse and manage risk. Nowhere else can this better be seen than at Pohjola Asset Management, where risk management is integral to all the company’s operations.

As part of the Finnish financial services group of the same name, Pohjola Asset Management offers both discretionary and advisory investment management services for institutional and private clients. As a well-respected asset manager for Finnish institutions and wealthy private individuals, the firm’s portfolio management services span European fixed income investments, Finnish, Pan European and Eastern European equities, hedge fund of funds, absolute return strategies and real estate investments.

Moreover, Pohjola’s portfolio management team of 36 is the nation’s largest and, together with open architecture of currently 37 international partners, it has posted impressive returns year-on-year. In addition, Pohjola’s 85 asset management experts oversee client assets worth approximately €39.2bn and, owing to thorough analysis, teamwork and management expertise, the company currently stands as the regional benchmark in how best to conduct the business of asset management.

Exposure to risk
The firm has seen risk reporting change drastically over the years. At present, financial institutions must take pains not only to accept, but to cater for, their exposure to risk. “I think first of all, lately there has been much more emphasis on stress testing, not just on the historical stresses, but in really understanding how large movements in market risk factor into a portfolio,” says Saariaho.

In addition to regulatory and technical changes, the perception of risk on the client side has changed drastically. Customers today are far more unwilling than they were to leave their assets in another’s hands without first knowing in detail their exposure to risk. “Clients ask for much more information on risk, so besides the total risk number, these days they expect risk contributions, and relative risks, they really want to understand where risk is taken,” says Saariaho. “Clients, increasingly, are interested in where their asset manager tackles risk. There too – I think – is one of the key elements in building that trust between manager and client.”

Therefore, more must be done to reassure clients about the integrity of financial firms, whether it be through consistent returns or by addressing the concerns of clients on an individual basis – as is very much the case with Pohjola. “I would say that better transparency is one important way to build trust between parties,” says Saariaho, “and trust in this business is very important.”

As with the wider financial services industry, transparency is arguably the single-most important factor on which a sound reputation rests, and it is for this reason that Pohjola makes clear its clients’ exposure to risk on a regular basis and in a clear and concise way.

Building a replicating portfolio
With regards to the specific mechanisms by which risk is identified and assessed, Pohjola employs a number of methods that take into account today’s turbulent markets and ongoing regulatory upheaval. “First of all, we really focus on market risks on the liability side,” says Saariaho. “Usually the client is able to provide expected cash flows, but there may be some optionalities embedded in the liabilities, which are quite difficult to model and may then result in the need for simulations.

“Once you get down to the cash flows, then basically the next step is forming a replicating portfolio, so it in effect is driving these risks within the liabilities using instruments like bonds and options. This replicating portfolio can then be fed into a market risk model, together with assets, for further analysis.”

With respect to specific risk metrics, Pohjola uses both value-at-risk and expected shortfall when it comes to identifying and describing portfolio risk. In addition, a comprehensive suite of stress tests is used to describe portfolio exposure to specific movements in market risk factors. The firm’s risk numbers are always based on a very thorough mapping of investments to their underlying risk factors, including look-through on mutual funds, index futures and benchmark indices, and it is this high precision approach to risk management that distinguishes the firm’s services from those of close competitors.

Working with regulation
Those working in the asset management space have found themselves forced to contend with seemingly endless regulatory demands, and while some believe regulatory upheaval is inhibiting the industry’s innovative streak, others see the process as part and parcel of appeasing clients. Unsurprisingly, those in the latter group have negotiated the regulatory mire with a far greater degree of success than those in the former category and are today able to cater for a much-changed client market.

One of the biggest regulatory changes of late is Solvency II, which in essence entails a fundamental review of the capital adequacy regime and ultimately seeks to establish a revised set of EU-wide capital requirements and risk management standards. “We’ve been working on Solvency II for a number of years now,” says Saariaho. “I think managing the interest rate risk in liabilities has really increased the use of derivatives. Also, developing portfolios, which are efficient from the regulatory capital viewpoint, has been and will be important in the future as the regulations start to take effect.”

However, the Solvency II directive represents a very small part of the wider regulatory landscape, and serves as an indication of the various ways in which asset managers are required to adjust their operations accordingly. Whether it be the Dodd-Frank Act, or the EU Alternative Investment Fund Managers Directive, a new and complex web of regulations is ramping up scrutiny and enforcement on all fronts, leading firms like Pohjola to review their compliance programmes.

As far as creating value and improving organisational dynamics is concerned, risk management is absolutely essential if financial firms are to adequately cater for an ever-changing market and consumer. And although the business of asset management is arguably more complex now than what it was a few years ago, the prospects of those able to endure the transformation are all the better for it. While it’s true that an increased emphasis on risk is closely in keeping with transparency and trust, it’s also responsible for a far more diverse approach to asset management.

Crucially, a sharpened focus on risk management has led many in the business to adopt a far more adaptable approach, and freed companies and clients alike from the consequences that come with irresponsible risk taking.