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Fitch says credit crunch suffered under 'reactive' systems

GLOBAL - Ratings agency Fitch has suggested investment houses with outdated risk management processes saw the worst of recent volatility and pricing uncertainty in the credit markets.

A report published by the ratings agency, revealing the lessons learned following the summer credit crunch, argues investment firms which "weathered" market turbulence best did so because they run "proactive rather than reactive risk management organisations" which differentiate them from other firms.

Fitch said the impact felt by the "disappearance of market prices" and firms' inability to price ‘net value asset' was an "oversight of risk management" caused by a lack of alternative procedures valuation, which saw experienced firms with previous experience of handling past crises fare reasonably well.

"Asset managers had…not experienced this kind of event before but will certainly have to build on the 2007 crisis to adjust their risk management practices, notably regarding the assessment of liquidity risk," said Fitch, in its report entitled Investment Management and Current Market Conditions: risk management in focus.

Commenting on recent "systemic risk" to asset-backed securities, Fitch continued in its report: "The marketed portfolio risk profile must appropriately reflect this so that investors are aware of the risk they are facing. In this respect, risk management professionals have a key role to play in several phases of investment design and management processes, from product inception through to ongoing monitoring, serving as a control point for achieving adequate asset diversification."

At the same time, Fitch also argued firms did not sufficiently understand the risk profiles of their clients, adding: "The flipside of portfolio risk profiling is understanding investors' risk aversion, which has been underestimated in some cases…most enhanced cash fund investors have expressed their tolerance, or lack thereof, through very large redemption flows over the course of the summer."

One key mitigant the firm appears to be recommending is the introduction - where not already applied - of a chief risk officer to the executive board, who has the ability to veto investment and business decisions where they believe al risks have not been sufficiently catered to.

That said, the firm - which rates the creditworthiness of an investment house and its products by looking at its risk management systems - is now warning there are still a handful of markets key to pension fund asset allocation which could still see further turbulence, namely property, commodities, infrastructure, currency and quantitative management in open-ended products with mark-to-market requirements have yet to be truly stress-tested by the markets.

"The challenge for investors is now to focus on asset classes and strategies that have not yet been fully tested… and that have gained considerable momentum in the recent past," said Fitch.

Interestingly, the report notes the impact on hedge funds and funds of hedge funds was, on average, not as much as in other asset classes - despite intense scrutiny of hedge funds at the time - as associated indices lost around 1.5% in August but more than recovered in the following months.
But one market which the firm believes is now suffering its first real test is the diversified absolute returns sector, as it was essentially built as a lower-risk fixed income market to counter equity market turbulence but contain a slightly higher level of risk.

Data issued elsewhere this week by rival ratings agency S&P Fund Services reveals just five absolute return funds - three from Fortis and two from Threadneedle - have performed well in the last three months to the end of October, as most in that sector lost money.

Fitch and S&P, as ratings agencies, have themselves been under fire from politicians as well as the financial industry since the August credit crunch for providing firms with credit ratings on products which some have argued do not reflect the eventual ratings they were given.

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