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Calculating the Impact of the Unimaginable

In July, forward-thinking fund managers were trying to figure out what might happen to their holdings if-heaven forbid-the unimaginable might occur.

In this case, the unimaginable was whether a major ratings agency might downgrade U.S. debt, given the fractiousness of American political decision-making.

In September, the scene replayed itself, as fund managers tried to figure out the ripple effect on all their assets if a member of the Euro Zone, namely Greece, were to default on its debt.

In each case, they didn't have to guess. In place were in-house systems or purchased software that allow them to gauge the risk of investing in a particular security or type of asset. And, in particular, gauge the overall effect on all their holdings of changes in macroeconomic conditions that might boost or whack the value of wide swaths of securities.

"Basically, it's extremely important and a very practical issue that you want to and have to slice and dice your holdings and your risk in various different ways,'' said Else Braathen, risk management domain manager for SimCorp, a supplier of investment software to fund companies.

Managers need to be able to break out potential impacts from expected and unexpected events on their overall holdings, on each individual fund, or on each "certificate." Fund managers also can monitor risks the security or position held level, on assets held in a given country, on assets held in a given currency, on assets held in a specific industry and other patterns of holdings where there is either an individual investment risk or a concentration of risk, Braathen said.

Key to this is the ability to draw on accurate market and enterprise data on all holdings at any time.

Software developers such as SimCorp, Charles River Development and Advent all point to the importance of being able to rely on a single database of transaction history on all funds and all holdings in a given mutual fund complex.

They supply "integrated" investment management systems and warn of the difficulty of "normalizing" data and re-using it in risk analytics, when a fund tries to use different applications from different suppliers for different kinds of assets, whether it be equities, bonds or derivatives.

At its core, SimCorp's Dimension suite of software is an accounting system, notes Brent Rossum, the company's front-office domain manager. This means that the details captured on a given transaction are fed directly into parts of the system that keep track of operating expenses, revenue and returns, to generate profit-and-loss statements and other financial reports. Reports which must stand up to scrutiny by independent accountants as well as federal examiners.

Before a trade, the system, for instance, can make sure that all requirements of fund guidelines are met, before an order to buy or sell is executed. The system also makes sure that all guidelines of a fund complex's investment policies are followed (see "How Enforcing Policy Attracts Funding,'' page 1).

"Post-trade is too late," Rossum said.

The ability to calculate investment and market risk beforehand is an important tool, in Braathen's view. Given the volatility of markets and the still rippling effects of the global credit and sovereign debt crisis, it's no longer good enough to do "look back" assessments on risks.

Now, companies can't just look at a major measurement such as Value at Risk on an enterprise level. That value has to be "sliced and diced" by fund, to come up with absolute numbers that a firm can expect with a certain probability to lose over a given period of time.

The dicing also has to be figured out not just in dollars or euros, but in the impact on the Net Asset Value of each fund, she says. And funds may have to layer on how the change in value compares to a financial benchmark that is used to measure the performance of the fund, as part of its investment guidelines.

Fund managers can use pre-constructed scenarios similar to the crisis of 2008 or a Greece default situation as defined by service providers to assess the consequences.

SimCorp and Advent, for instance, also provide tools that allow fund managers-or their programmers-to create custom scenarios to be applied against their holdings. This can involved worst case assumptions for spreads, for currency values, for commodity prices or other factors that affect national, regional or global economies, and the like.

Advent prefers to give customers the tools to build their own scenarios, because, many times, the funds involved consider risk assessment to be a major competitive advantage. "These people don't like to share their secrets,'' said John Bird, director of product marketing.