A CRO must also have the ability to counter a culture that may be focused on short-term gain rather than the long-term interests of investors, she says. Short-term bonuses are just one example of the mechanisms that could work against a long-term perspective.
"A CRO must be willing and able to make tough decisions that could truncate short-term gains for an organization and instead position an organization for longer-term survival," Mangiero says.
A CRO must often solicit help from people who may be overworked and/or not interested in seeing their short-term upside capped, she says. "This requires tact and [the ability to convince] those at the top to foster an organization-wide risk culture focused on risk management and not undue risk-taking," she says.
Brian Newton, the chief risk officer at Armored Wolf, an Aliso Viejo, Calif.-based hedge fund, believes that there are a number of issues investors should look at when they examine a hedge fund's risk culture. Three of the most significant questions that need to be asked will tell the investor if the CRO really has the ability to manage risk, or if he is merely a paper tiger, he says.
The first thing to ask is, to whom does the CRO report? At Armored Wolf, the CRO reports to the chief executive officer instead of the chief investment officer because the company believes this reduces the potential for conflict and helps mitigate risk, says Newton. It depends upon the structure of the firm, but a CRO should never answer to a trader, portfolio manager or chief investment officer because that would completely undermine the CRO's position and render it meaningless, he says.
While he should remain independent of the investment team, the CRO must also recognize the critical need for an effective professional relationship with the investment team. Regardless of how comprehensive a monitoring and reporting system might be, there will always be issues that are outside the scope of these tools. In those instances, the investment team must bring such items to the CRO and agree on the best way forward, Newton says.
Next, an investor needs to know how the CRO is compensated. The CRO's compensation should be directly tied to performance, which adds another layer of risk control, Newton says.
Portfolio managers should have incentives to proactively manage the risks they take in seeking returns in their respective sectors. For example, at Armored Wolf, capital allocation to portfolio managers is affected by performance, with both drawdown and outsized return being penalized, Newton says. The thinking is that realized risk is relevant and that the magnitude of returns is positively correlated with the risk taken, he says. The penalties are asymmetric, with drawdowns more heavily penalized, but outsized upward moves also result in capital allocation reductions.
The CRO and all portfolio managers have deferred compensation invested in the fund, so to the extent the fund suffers drawdowns, all are directly affected, Newton says. In addition, a portion of the CRO's deferred compensation is subject to forfeiture in the event of large drawdowns within a calendar quarter. This incentive focuses the CRO and is intended to overcome any reticence to either close risky positions or use hedging trades to ameliorate risks attendant with risky positions that may be viewed as too expensive to close. An example of this would be an emerging market position that has ex ante risk heightened by, for example, an election after which risk should revert to a more acceptable level. Closing and then reopening the position would be costly.
The third question: Can the CRO pull a trade off the table? A risk officer who is being given proper leeway to do his job should have the ability to pull a trade off the table if he has ample reason to believe that the portfolio is at risk, Newton says. If the portfolio manager or chief investment officer can override the decision, then the CRO has no teeth and cannot be effective, he says.