Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

In a recent excursion to my local Starbuck's, I surprisingly discovered that a major drugstore chain had moved in over the weekend, installing its equipment at the former location of a privately-owned pharmacy. Those in the know say that the 80-year old "mom and pop" business was urged to sell or see its national competitor move in across the street. The message was pretty clear. Sell or lose revenue to a well-capitalized opponent.

Competition is nothing new. Some experts consider healthy competition to be the lifeblood of a capitalist system. Consumers almost always benefit from lower costs, expanded inventory and/or better service. Yes, some rue the day when large chain stores muscle out local vendors. Remember the Shop Around the Corner children's bookstore that was pushed into oblivion by Fox Books as portrayed in You've Got Mail? Protests to preserve the charm of Meg Ryan's operation gave way to the appeal of being able to choose from a large selection of books while sipping a cappuccino from the cafe of Tom Hank's mega-store.

However, what is good for some may not be so for others. Shareholders of a company that faces more competition may see the value of its interests decline, depending on the ability (and associated costs) of a firm to respond. If the company operates as part of a mature industry, maintaining (or improving) profit margin and market share has its challenges.

As a trained appraiser and someone who serves as a financial expert on matters that involve questions about valuation, investment performance, risk-taking and suitability, I am surprised whenever I discover that the issue of competitors has not been duly vetted. Investors need to carefully monitor the competitive landscape on an ongoing basis, whether to partake in an Initial Public Offering, approve an exit via acquisition or merger or rebalance their holdings.

The folly of ignoring the threat of competition (or at least giving it short shrift) is the topic of a March 21 article about Lululemon. According to Business Insider's Ashley Lutz in "The Walls Are Closing In On Lululemon," intense competition is giving this retailer a headache and arguably worsening the economic impact of a recall of 17 percent of its black luon yoga pants for being too sheer. Nike, Under Armour and the Gap are some of the firms that offer "very similar products in response to Lululemon's popularity." In another Business Insider piece, Athleta, Calvin Klein, Old Navy, Gaiam, Victoria's Secret and Nordstrom are other cited firms that want to monetize the buying habits of the downward dog crowd. See "15 Hot Brands Vying To Be The Next Lululemon." This increase in competitive pressure comes as no surprise to me. As a devotee of yoga, I can understand why someone would go elsewhere to buy pants at $30 a pop versus $100, especially if you are likely to frequently replace workout clothes because of wear and tear. That said, Lululemon (ticker symbol is LULU) has enough high ticket buyers to have grown from its 1998 start in Vancouver as a health-focused "community hub" to nearly 200 stores worldwide with a market capitalization of over $9.33 billion (according to Yahoo! Finance).

Whether Lululemon can bounce back quickly is a hot discussion item this week. According to "Lululemon Expects More Write-Offs on Pants" by Wall Street Journal reporter Andrew Dowell (March 21, 2013), the true costs of the recall remains to be seen. One reader offers that the increased publicity could work in the company's favor to generate more visibility and therefore more sales. During a March 21 earnings call, Lululemon's CEO Christine Day described strong fundamentals, excellent results in 2012 and a commitment to "earn the loyalty of our customers and shareholders every day going forward." She comments that 2013 results will likely reflect "lost revenue in the range of $57 million to $67 million" plus additional costs related to the write-down of the yoga pants in question. See "lululemon athletica inc. announces fourth quarter and full year fiscal 2012 results."

According to the NASDAQ website, 337 institutional holders own 96.34 percent of Lululemon shares. These include Capital World Investors, Lone Pine Capital, Fidelity, JP Morgan, Ameriprise, UBS and Vanguard.

Join me on May 1, 2012 for a timely and interesting program about alternative investment fund due diligence and other considerations for ERISA plan sponsors, their counsel and consultants. Click here for more information.

This CLE webinar will provide ERISA and asset management counsel with a review of effective due diligence practices by institutional investors. Best practices will be offered to mitigate government scrutiny and suits by plan participants.

Description

With the DOL's and SEC's new disclosure rules and heightened concerns about compliance and valuation, corporate pension plans that invest in alternatives must focus on properly vetting asset managers more than ever before or risk being sued for poor governance and excessive risk-taking.

The urgencies are real. The use of private funds by asset managers is crucial for 401(k) and defined benefit plan decision makers. Understanding the obligations of private funds is essential to any retirement funds with limited partnership interests.

In addition, suits and enforcement actions against asset managers make it incumbent on counsel to hedge fund and private equity fund managers to fully grasp and advise on full compliance with the duties of ERISA fiduciaries to plan participants.

Listen as our ERISA-experienced panel provides a guide to the legal and investment landmines that can destroy portfolio values and expose institutional investors and fund managers to liability risks. The panel will outline best practices for implementing effective due diligence procedures.

Outline

Benefits

The panel will review these and other key questions:

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

Faculty

Susan Mangiero, Managing Director
FTI Consulting, New York

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Alexandra Poe, Partner
Reed Smith, New York

She has over 25 years of experience in investment management practice counseling managers of hedge funds, private equity funds, institutional accounts, mutual funds and broker-dealer advised programs. She counsels hedge and private equity fund advisers in all stages of their business and due diligence matters.

In a recently published article about financial models entitled "Financial Model Mistakes Can Cost Millions of Dollars" (American Bar Association, Section of Litigation, Expert Witnesses, May 31, 2011), Dr. Susan Mangiero defines model risk and explains why it is so important. Referencing the recent $242 million enforcement action by the U.S. Securities and Exchange Commission as a result of model mistakes made by a well-known asset management firm, this financial expert cites the heightened regulatory and litigation imperatives with respect to risk and valuation models. She concludes the article by listing some of the ways to mitigate risk. These include, but are not limited to the following:

• Hire knowledgeable programmers with capital market experience;
• Create and follow a set of policies and procedures that govern how and who will validate financial models over time and what will trigger revisions in a model(s);
• Avoid conflicts of interest that would reward managers for ignoring problems and would potentially preclude an independent and objective assessment of problems and related corrective action(s);
• Test assumptions for validity in stable markets as well as extreme circumstances;
• Stress a model using a sufficient number of economic scenarios to gauge its predictive power and whether results can be relied upon in both good or bad times;
• Educate personnel about how a particular model is supposed to work;
• Establish a response strategy should a problem occur and investors need to be informed before things get out hand;
• Scrap models that are overly complex and expensive to replicate;
• Don't be afraid to ask questions about inputs, data quality, results, and concerns; and
• Invite informed outsiders to offer an independent and regular critique on a confidential basis.

In reading the published accounts of the U.S. Securities and Exchange Commission ("SEC") settlement with the AXA Rosenberg Group and various related entities, I'm reminded of many articles I've written that warn about the limitations of models and the critical need for ongoing tests and oversight of said models. According to the document published today regarding the AXA Settlement With the SEC, certain senior managers who were apparently made aware of a coding error (that "was introduced in 2007" and discovered in late June 2009) responded by instructing junior staff to "keep quiet about the error."

Models are designed by human beings and require constant care and feeding. For one thing, market conditions change which therefore requires that models be revisited for their accuracy and the extent to which underlying assumptions still hold true. Second, most investment models are complex in that multiple calculations are used to generate final outputs. Third, some models are "nested" in the sense that data inputs for an ultimate algorithm are themselves modeled.If the modeled inputs are flawed, it's no surprise that Garbage In, Garbage Out ensues.

For example, interest rate paths (levels, direction, volatility) and prepayment assumptions are integral inputs for mortgage backed security pricing models yet must first be modeled. If rates have just fallen considerably and a large number of home owners have refinanced, another fall in interest rates is unlikely to encourage yet another large spate of prepayments. The underlying assumptions that drive interest rate paths directly influence the estimates of time-valued projected cash flows associated with the mortgage bond so questions must be asked about how the inputs and the outputs are generated.

Model errors are seldom self-contained and create a Pandora's box for those investors or traders who commit money to the "wrong" numbers. Let me elaborate.

Suppose a trader hedges a portfolio of securities based on incorrect model outputs. The net result will be protection that is excessive (thereby costing that trader in the form of opportunity costs) or insufficient (thereby forcing the trader to realize losses that were meant to be avoided).

Another situation relates to end users that allocate part of their portfolio to a quantitative investment strategy such as pension funds or endowments. If the "quants" get it wrong because of sloppy modeling work (and that includes errors that are not caught right away because of poor oversight, bad math or both), these institutional or individual investors have unnecessarily lost money as well as the opportunity to have allocated elsewhere. According to "AXA Rosenberg to Pay $242 Million Over 'Coding Error'" by Jakema Lewis (Securities Technology Monitor, February 3, 2011), the School Employees' Retirement System of Ohio, Los Angeles Fire and Police Pensions, the City of Fresno Retirement System, Florida State Board of Administration and the Montana Board of Investments voted with their dollars by terminating their respective relationships with AXA Rosenberg. According to "AXA Rosenberg finds coding error in risk program" by Mark Weinbraub with Jennifer Ablan, Reuters, April 24, 2010, the Marin County Employees' Retirement Association pulled $16.5 million from an AXA Rosenberg international small-cap portfolio.

Email contact@fiduciaryleadership.com if you are interested in learning more about investment model due diligence. In the meantime, articles listed below provide information about model risk:

• "The Risks of Ignoring Model Risk" by Susan Mangiero, Chapter 5B, 2005 Cumulative Supplement to the Litigation Service Handbook: The Role of the Expert, John Wiley & Sons, 2005
• "Asset Valuation: Not a Trivial Pursuit" by Susan Mangiero, FSA Times, Institute of Internal Auditor, Q1-2004
• "Financial Model Risk Looms Large" by Susan Mangiero, The Investment Lawyer, November 2002
• "Model Risk is Serious Business" by Susan Mangiero, "Derivatives Diary," AFP Exchange, September/October 2002

Every investor must exercise care and diligence in asking tough questions and being satisfied with the answers. At a bare minimum, this requires that each investor:

• Gain an intuitive understanding of the model and what results should raise red flags because the "smell test" fails
• Ask to meet with the architects of the model and have them explain how they stress the model and whether there is a consistent error rate associated with outputs
• Understand the data issues and whether quality varies across vendors, how outliers are identified and addressed and whether the model is sensitive to frequency and form of data inputs
• Inquire as to who has the authority to modify the model and on what basis
• Query whether internal and external auditors are comfortable with the traders' model(s) and if not, explain their concerns.

Risk management is about so much more than good numbers. Process is everything and that includes comprehensive oversight of the models and when they are likely to fail and for what reasons. Common sense is a critical component of managing risk and will never be replaced by a number or computer. Keep in mind too that with FAS 157 and international accounting equivalents, not to mention U.S. Department of Labor mandates for ERISA plans, an investment fiduciary who invests in complicated strategies and/or securities on the basis of a "black box" approach is just asking for trouble.

While preparing for a recent keynote speech about stable value fund risk management, I took a dinner break at a local Chinese restaurant. After a satisfying meal, I reached for the fortune cookie. Lo and behold, the message eerily resembled the nature of my talk that was scheduled for the following day.

"All things have a cause. Look into your past for answers."

While I am not a big believer in relying on historical performance numbers as a bellwether for future returns, it is reasonable to question what went wrong n the last few years. Indeed, lessons learned about risk management failures and how investors should better protect themselves going forward are sunny spots in an otherwise gloomy economic climate.

Here are a few of my favorite strolls down memory lane with hopes that organizations will use the rout of the last several years to improve their existing oversight structure and risk controls.

• Numbers are only as good as the inputs and assumptions used to create them. Additionally, risk management goes well beyond numbers. How many hedge funds had terrific Sharpe Ratios in 2008 and 2009 but lousy operational or financial stop-loss points?
• Use independent third party vendors to kick the tires on mark-to-market or mark-to-model numbers for hard-to-value positions. U.S. and non-U.S. regulators have been none too shy about making their concerns about the integrity of valuation reports, indicating that statutory mandates are coming our way in short order. 
• Ask questions if performance appears too steady or too robust. Unless an asset manager is artificially smoothing out returns, investors should expect some bumps along the way. No one gets the trades right all the time.
• Institutional investors should ask to meet with an asset manager's Chief Risk Officer, demand to read the fund manager's risk management policy statement and understand how traders are compensated. The goal is to avoid investing with cowboy (or cowgirl) traders who are motivated to take unnecessary risks because their bonuses are tied to inflated performance numbers.
• Ask about how leverage is measured and managed. The use of other people's money, whether through borrowing, short selling, margin transacting and/or use of derivatives, has pros and cons. In bad times, leverage is your worst enemy because it magnifies losses. Moreover, a highly levered position(s) could force cash outlays at a time when available cash is limited and the ability to borrow more money is nigh impossible or extremely costly.
• Banish the term "risk-free" from your investment lexicon. Nothing is risk-free. Even putting money under one's mattress is risky if the house goes on fire. Countless investment vehicles have been touted as "low risk." Expect unhappy investors to seek redress from asset managers, advisors and consultants if performance is negative or sub-par. The tolerance level for sloppy risk management, post Madoff, is low.

Future posts will discuss other aspects of investment best practices and financial "no no's." In the meantime, early February 2011 marks the Year of the Rabbit and a time for caution about investing. Embracing an enterprise risk management focus is sure to go a long way towards calming a fear of the unknown.