The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Reducing Operational Risk — a Matter of Nurture, not Nature

By Ross Ellis, Vice President, SEI Knowledge Partnership

Q4 2012 edition


Every investment management firm knows that even seemingly minor operational oversights or mistakes can have huge repercussions. That’s why operational departments work hard to automate and fail-safe their processes, conduct extensive reconciliations, and develop detailed workflows and procedures. A great deal is at stake, and not just in terms of direct financial costs and legal liability.  To paraphrase Warren Buffett, it takes 20 years to build a reputation…and, in some circumstances, just one operational mishap to ruin it.  This is why operational risk is of such concern not only to investment management firms, but also to their clients, investors, regulators and trading partners.  

Of course, some firms take a more rigorous approach to operational risk management than others. The trouble is, whatever level of effort they devote to that goal, it’s all too easy for firm executives and departmental managers to think “we’ve got that covered” or “we’ll get to that later.” But as experience has shown time and time again, investment firms often fail to see their vulnerabilities until some disaster makes them all too clear.  

I’m not talking just about the fallout from natural calamities like Hurricane Sandy. Investment firms face many more insidious risks: The records that can’t be located when some client assets are misplaced. The new product that gets launched before operational systems can be adapted to accommodate it. The junior employee who quits without notice — and turns out to be the only person who understands all the ins and outs of a certain process. The functions that go awry when new software fails to mesh with the legacy system. In our business, risk is an omnipresent and many-faceted thing.         

So why do decision-makers and managers so often give the crucial task of risk management less than its due?  One obvious answer is that they’re hard pressed just to keep up with the daily demands of high-velocity, high-volume operations. Then too, many operations departments have sustained deep cuts in their budgets and staffing as a result of the financial crisis and recession, leaving them even more resource-challenged than usual. 

The field of evolutionary biology gives us another reason why investment firms may be less than thorough in dealing with operational risks: it’s human nature. Our species has evolved with a fight-or-flight mechanism that equips us to deal with immediate, palpable perils like a hungry wolf or a menacing stranger. We also respond to situations that affect us personally or touch us emotionally. But more abstract, far-off threats?  Not so much. 

This is why people may be far more distraught over one missing child in their neighbourhood than they are over the estimated 140,000 who go missing in the UK each year. One brings tragedy to our doorsteps; the other is a statistic. It also explains why voters often name the economy, taxes and health care as their biggest concerns while putting climate change far down the list. A personal hit to the chequebook feels more alarming than a global weather shift that could possibly threaten our entire planet somewhere down the line.      

Studies also show that when you ask people to predict their future well-being—whether concerning their health, their expected earnings, or anything else—most will see themselves as being better off than the norm.  Like the residents of Lake Wobegon, the fictional town created by author and radio personality, Garrison Keillor, we expect to be above average.  Academics call this “optimism bias,” and it, too, appears to be baked into our DNA. 

Why is this relevant to the business of investment management? Because it highlights the reasons why executives and operational managers need to be especially proactive in tackling the job of risk management.  If we understand that our natural inclination is to believe we’ve done enough and things will be all right, we can apply the intellectual focus and management discipline it takes to overcome that.   

The problem, of course, is where to begin. Operational risk stems from so many sources, and involves such a complex set of players and systems, that improving a firm’s risk profile can seem like overwhelming task. Another hurdle is the fact that different organisations have different exposures to operational risk, depending, for instance, upon their investment strategies, the markets in which they operate and the instruments they employ. As with investment risk, firms also have varying tolerance levels for operational risk.  Consequently, there is no all-purpose checklist for identifying operational risk, nor is there a single, universally applicable set of mitigation measures.

Virtually every investment management firm has the opportunity to take risk management to a higher level.  That means taking a fresh look at common areas of risk, identifying priorities for action, and then considering the variety of relatively straightforward risk-management measures that can be deployed. This need not entail some massive, hugely time-consuming effort.  In fact, with some discipline and perseverance, a piecemeal, iterative approach may be more effective than a “big bang” approach. 

To make the job easier, SEI recently published Top Ten Operational Risks, an online guide that catalogues a host of operational pitfalls along with potential ways to remediate them. The guide is available as downloadable chapters at It deals with areas of risk that keep popping up in operational reviews. Broadly speaking, these include concerns with personnel, supervision and training; organisational and support issues, including the roles of technology, which can be a both a solution and a source of risk in itself; and common weaknesses in reconciliation, legal review and planning.    

It has been observed that operational risk offers no upside; it is risk without reward.  In contrast, concerted and systematic efforts to reduce operational risk promise a clear upside. Not only can they help investment firms build a culture and framework for operational excellence, they create tangible investment value by reducing costs, increasing client satisfaction and reinforcing sound business relationships with trading partners. What’s more, many risk-mitigation measures are inexpensive, demanding more in focus and foresight than in hard investment. In these times of shrinking asset pies and stiff competition, the advantages to be gained through better risk management may be the real low-hanging fruit.

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