Manage Your Risks: How to Differentiate Between Investment Risk and Operational Risk

This article originally appeared in Smart Business Philadelphia magazine.

A fundamental investing concept is that investors need to be compensated for taking on additional risk. However, investors often do not anticipate operational risks, and as a result, are often not compensated for them, says Todd E. Crouthamel, director, Audit & Accounting, at Kreischer Miller, Horsham, Pa.

“Operational risk can be difficult to price into the risk premium because human error is unpredictable,” says Crouthamel. “Therefore, many investors are left to assume that human errors will be prevented by the managers’ systems and controls, in order to rationalize hiring that manager. However, this is not always the case.”

Smart Business spoke with Crouthamel about how to differentiate between investment risk and operational risk.

What is investment risk?

Investment risk can be defined simply as the risk that the actual return on an investment will be lower than the investor’s expectations. Many investors are able to assess investment track records and investment models to decide if the potential rewards are worth the perceived risks in an investment. This type of risk is also readily measurable using various statistical measures, including:

  • Alpha, the excess return of an investment relative to the return of the benchmark
  • Beta, the measure of a volatility relative to the overall market
  • R-squared, the measure that represents the percentage of an asset’s movement that can be explained by movements in the benchmark
  • Standard deviation, the measure of the dispersion of data from its mean
  • Sharpe ratio, which describes how much excess return is generated for extra volatility of holding an asset

What is operational risk?

The ratios described above are all built on certain assumptions, including that volatility equals risk. These ratios all derive risk measures based on quantitative factors; however, they do not consider qualitative factors, including the investment manager’s internal controls, design and implementation of its systems, and oversight of its employees. This is operational risk.

Human error makes operational risk unpredictable. Many investors may assume that human errors are prevented by the managers’ systems and controls, but that is not always the case. Consider the following situations:

  • You hire Manager A to manage a large cap equity portfolio, and instead, Manager A finds better opportunities in the small caps and rationalizes investing your portfolio in small caps in the interest of earning you a better return. This guideline violation results in your portfolio being overweighted in small caps and minimizes your exposure to large caps.
  • Manager B was recently examined by the Securities and Exchange Commission (SEC) and the SEC concluded that Manager B’s compliance program was wholly inadequate.
  • Manager C has a trader with inappropriate access rights to override controls in the compliance system. The trader executes trades that are in violation of the investment guidelines and conceals these through the inappropriate access rights so these securities are not identified as investment guideline violations.

These examples are real. While some of these risks may be identified in the risk measures described previously, many go undetected until disaster strikes and losses pile up.

How can investors protect themselves from operational risk?

Elimination of operational risk is virtually impossible; however, it can be mitigated with some additional due diligence. Consider the following best practices:

  • Review the Form ADV. If your investment manager is registered with the SEC, go to www.adviserinfo.sec.gov and read the adviser’s Form ADV, which consists of two parts. Part I provides details on the business, ownership, client base, employees, affiliations and disciplinary actions. Part II is a narrative that describes the services offered, fees, conflicts of interest and the backgrounds of management. Make sure that this information is consistent with what you already know about the adviser. If you are uncomfortable with any of the disclosures, make additional inquiries of the investment manager. If you are still not satisfied, consider another manager.
  • Read the investment manager’s most recent SEC examination letter. The SEC conducts routine examinations of investment managers’ compliance systems and issues a letter detailing violations and enhancements that the investment manager should make. If your investment adviser is reluctant to share this letter with you, consider another manager who is more transparent.
  • Make inquiries of the investment manager regarding its systems and internal controls surrounding compliance with investment guidelines. The compliance system should be automated, and overrides of transactions outside of the investment guidelines should require more than one sign off, preferably by someone who is independent of the trading and investment management process.
  • Make inquiries of the investment manager regarding the financial strength of the company. An investment manager that is having financial difficulties may be more likely to take bigger risks.
  • Read the investment manager’s report on internal controls. Many investment managers have a report that is prepared by an independent third party that tests various internal controls surrounding establishing new accounts, trading, reconciliation and accounting. This report generally details the testing performed and the results.
  • If you are not confident in your ability to conduct operational due diligence, consider hiring a third party to conduct it on your behalf.

While these best practices may reduce your exposure to operational risks, there is no substitute for a healthy dose of skepticism. If an investment manager’s returns look too good to be true, they probably are.

Todd C. Crouthamel, Director, Audit & Accounting can be reached at tcrouthamel@kmco.com or 215.441.4600.

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