Asset Manager of the Year: AQR Capital Management

AQR applies quantitative knowledge to assess op risk for new models

Graeme Farrell (pictured left with Simeon Fishman): we deploy tools “going above and beyond the traditional qualification and quantification of op risk”

Asset managers increasingly need to support clients with customised investment tools, but building them creates new operational models – and, potentially, new risks. While many asset managers have developed quantitative models for investment, AQR Capital Management has distinguished itself by transforming these capabilities into quantitative op risk analytics.

It uses these analytics to understand and manage the cost of operational risk in its processes and products, bringing a level of understanding typically seen in market and credit risk management, which led Risk.net’s judges to give AQR the award for OpRisk Asset Manager of the Year.

Reflecting the consensus of the panel, one judge said the op risk team of the asset manager, run by Cliff Asness, is “demonstrating forward thinking in their analytics and analysis by combining several disciplines of operational risk into a progressive approach to evaluate risk across type and funds”.

Graeme Farrell, managing director and head of operational risk at AQR, says the firm aggregates and analyses risk and business data quantitatively, informing its calculations with bespoke proprietary reference data.

“This framework leads to risk insights that are more precise and defensible,” he says. “We deploy operational risk management tools, going above and beyond the traditional qualification and quantification of operational risk, to generate a more actionable outcome.”

AQR believes its predictive quantitative approach gives it a leg up in business decisions. This doesn’t mean aspiring to eliminate op risk any more than a fund manager would view that as an appropriate goal when considering a fund’s market or credit risk. Rather, AQR wants a rigorous understanding of its risks, so it can both mitigate them where necessary and price its products to reflect the risk that remains. The company has created three tools to achieve this.

Trio of tools

To identify and assess process risk at firm, group and departmental levels, AQR has developed what it calls Aggregated Risk Profiles (ARPs). These use standard risk tools to identify and assess risk data at different points in time using qualitative and quantitative means. They can include operating metrics, key risk indicators, risk and control self-assessments, process mapping, targeted risk assessments, event analysis and scenario analysis.

This allows AQR to drill down to the root drivers of any threatening trend, and the potential effectiveness of the response of the firm’s control environment. It provides a holistic, comprehensive view on risks, trends and exposures.

We had senior individuals throughout the firm identify and assess upwards of 15–20 factors. We had leaders, including portfolio managers, determine how to measure each factor

Graeme Farrell, AQR Capital Management

The second tool is a framework to quantify op risks at the fund level, called Fund Factor Risk Analytics. It analyses each fund’s risk factors and aggregates them to capture the product’s overall risk profile. This is key to creating investments for clients that balance their performance goals with the operational risk to the firm.

“It was a firm-wide effort to determine what factors are [the] best proxies for operational risk,” Farrell says. “We had senior individuals throughout the firm identify and assess upwards of 15–20 factors. We had leaders, including portfolio managers, determine how to measure each factor.” He notes the firm is constantly refining the approach.

Each operational risk factor was assigned a rating from ‘one’ to ‘five’. For example, the firm ranks the volume and complexity of customised fund investment constraints, giving funds with highly customised constraints the highest risk and unconstrained funds the lowest rating.

Each factor was assigned a percentage ranking to aggregate them appropriately, by linking them to operational risk at the process level, determined by the ARP. The result is an assessment of op risk for all funds throughout the firm, both individually and aggregated by group, such as by fund families or legal vehicles.

With these two tools, AQR has a multidimensional view of operational risk at both the process and product level, allowing it to identify and remediate exposures.

Economic impact

The third tool is AQR’s Operational Risk Adjusted Returns (ORAR) framework, which determines the economic impact of operational risks and the cost of their mitigation. It is important for the op risk team to be able to articulate this information credibly to the business so it is not seen as simply a limit to product development.

The firm can identify the range of ORAR for all funds, along with their drivers. It can also determine the potential ORAR of new funds. By examining the operational complexity of the fund, and therefore its risk, as well as its fees for assets under management, AQR can estimate the ORAR per unit of assets under management and price it into the fee structure of new products accordingly. 

AQR’s own flagship Multi-Asset Fund Class I returned only 0.33% in the 12 months to May 31, while a 60/40 MSCI World Index NR/Barclays Global Aggregate Bond Index mix returned 2.71%, despite notching record gains of 9.6% in the first quarter.