Business-level investment risks are getting more attention from money managers, but the new focus doesn't go far enough, Bernhard Scherer contends.
In a new white paper, Mr. Scherer, professor of finance at EDHEC Business School in London, suggests money managers should hedge market risks from their businesses to protect their shareholders or other owners from investment volatility.
Such hedging would preserve capital to fund new projects and bring alpha generation into sharper focus, the paper said.
It also would improve the link between compensation and adding value to shareholders, which would motivate employees to generate alpha, attracting those skilled in doing so while pushing out employees who rely on beta exposure for returns, according to the paper, “Market Risks in Asset Management Companies.”
The recent global financial crisis challenged the belief that money management companies' greatest risks were operational, as tumbling asset values caused widespread layoffs and other cost-cutting measures, and managers “came under severe profitability pressure from market, not operational, risks,” Mr. Scherer wrote in the paper.
“Asset managers have been increasingly doing a better job at hedging investment risk,” Mr. Scherer said in an interview. “But all this is focused on managing clients' risks.”
Mr. Scherer acknowledges examples of managers hedging market risks are rare. He writes: “Asset managers do not hedge market risks even though these risks are systematically built into the revenue-generation process. This is surprising as shareholders would not optimally choose asset management companies as their source of market beta. They rather prefer to participate in the alpha-generation and fund-gathering expertise of investment managers as financial intermediaries.”
And it's not just large, publicly owned managers that would benefit from hedging, Mr. Scherer said. “If the asset management business is owned by its employees, the argument is even more compelling.”
But Ralph Campbell, finance director at Martin Currie Investment Management Ltd., Edinburgh, said just the opposite is true at his firm, which is owned mostly by employees. Because employees are also owners, bonuses act as a natural hedge, dropping drastically after a market shock to boost profitability of the business.
“It's easier to do that when you know you'll get the benefit from (long-term) market appreciation (as an owner),” Mr. Campbell said. The firm would not likely ever want to hedge out market risks, he added.