Joanna Welsh, Citadel’s chief risk officer, spends her days in front of the big screens and blinking lights of its futuristic-looking Risk Management Center – a sort of ship’s bridge where information is collected to provide a real-time view of the firm’s investment portfolios and the risks they face.
As chair of the $31 billion manager’s portfolio committee and head of the portfolio construction and risk group, she has helped pilot Citadel through this year’s several bouts of market tumult – February’s volatility spike, selloffs in emerging market currencies, the topsy-turvy behaviour of big tech stocks.
“I think about it like a ship where small bits of continuous steering are more effective day-to-day than making major reactive corrections,” Welsh says.
Citadel has found safe passage. Risk.net understands the firm’s flagship multi-strategy fund returned more than 12% net of fees year-to-date, through the end of October. The HFRX global hedge fund index has lost more than 5% over the same period.
The risk management centre plays a big role. “We are always expanding the way we deploy technology for risk management; for example, using the risk centre to display the status of pre-trade checks and guidelines for all businesses,” Welsh says.
But Citadel receives this year’s buy-side risk management award not just for its centralised risk management technology but for its forward-looking approach.
Welsh was hired by Citadel chief Ken Griffin last year to deploy a more dynamic style of risk management, and under her stewardship the risk group has turned its attention to more accurately forecasting what could lie ahead.
A key idea is to reduce the danger associated with looking at markets purely using past data as a guide. Welsh thinks about it as avoiding “the history trap”.
In the area of average daily trading volumes – which feed into many mission-critical risk metrics from transaction cost estimation to liquidity risk modelling – Citadel this year abandoned the industry-standard backward-looking approach of predicting volumes based on previous days’ trading, and assembled a new predictive model that takes into account effects from a set of market factors the firm has identified.
An added bonus, Welsh says, was the analysis the firm was able to carry out to understand the flows that drive trading volume.
Another area where Citadel’s risk management team has revamped forecasting is the estimation of risk in the gas and power markets. Here the firm realised that changes in the sector could undercut the reliability of models based on past data.
Take, for example, the impact of a gulf coast hurricane. Five years ago, US gas was collated and shipped mainly from one specific area. Now shale provides a more widely distributed source of gas and that means the impact of a gulf coast hurricane is potentially less severe.
“These markets are always evolving. So what we said was: can we get a better forward estimate of volatility than the one we have now?” Welsh says.
Citadel is confident that the resulting model – which incorporates forward-looking information –delivers superior estimates of the firm’s peak risk in the sector.
Finally, 2018 saw Citadel make improvements also to its stress-testing.
Welsh started to wonder if there were transient, structural risks that might be currently classified as idiosyncratic in the firm’s equity risk models.
Drawing on its work on equity factors, the team analysed historical datasets of sentiment scores for news records, filtered by keywords, to help determine which securities were most and least impacted by certain macro and geopolitical events such as trade wars.
The research enables the firm to estimate risk for these transient themes, such as policy developments or tariff changes. In the past these risks had been modelled using historical scenario analysis as a starting point.
“Forward-looking scenarios are a standard tool but what’s nice about this is that it’s completely consistent with our existing equity model, not separate from it,” Welsh says.
Co-operation is key
Welsh accredits Citadel’s success this year to the co-operative relationship between the risk management and the investment side of the business.
“It’s important for risk management to have a close connection to the business and part of that involves hiring risk managers who are not only deep experts on specific markets but are also excellent communicators who can collaborate effectively with business leaders to solve problems,” she says.
“The risk process is here to complement the investment process. We seek to invest where we have the most edge and our risk analyses should increase transparency around the range of potential outcomes.”
Looking ahead, with central banks bringing the era of quantitative easing to an end, macro forces are in the spotlight at Citadel as they are across the industry.
This year the firm hired Gabriele Sarais as head of risk for macro strategies from Goldman Sachs where he served as global head of front-office risk in the securities division.
“We always have to think about the interconnectedness of our business. Because we have to fit many things together, just knowing the risk numbers for individual businesses is not enough,” Welsh says.
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