From Hedge Fund Insight
Chicago-based Citadel LLC, through it’s two huge flagship funds, put in a good first quarter performance with a gain of 6.35%. The $29bn firm is one of the biggest hedge fund managers in the world, and has been run by CEO Ken Griffin since inception. He oversees more than 675 investment professionals, and the hedge fund and market-making businesses operate from offices in New York, San Francisco, London, Hong Kong and Shanghai, as well as the Windy City. The firm is essentially owned and controlled by Griffin. Citadel deploys capital across all major asset classes through six investment strategies: Equities, Fixed Income and Macro, Commodities, Credit, Quantitative Strategies and Event Driven.
Disciplined risk estimation and management are deeply integrated components of the investment process across each one of the strategies. The firm takes a front-foot posture on risk management, as it states that it seeks to manage risk in order to capitalize on opportunities and improve performance. “The risk process is here to complement the investment process,” explains Chief Risk Officer (CRO) Joanna Welsh. “We seek to invest where we have the most edge and our risk analyses should increase transparency around the range of potential outcomes.” At Citadel risk management is a core competency, and is resourced and treated as such.
Citadel’s risk management is focused on three main tasks: risk capital allocation, stress exposure and liquidity management. Further, it contends that a well-constructed portfolio upfront will outperform in good markets and protect its’ client’s capital in difficult markets. In pre-trade discussions, the Portfolio Construction and Risk Group (PCG) works to identify the impact of potential trades on a portfolio’s risk and stress exposures. In the ex-post analysis, the group evaluates the skill, infrastructure, investment universe, risk and working capital utilization of each business, and uses this information as a part of the risk capital allocation process. In these ways portfolio construction and the PCG’s risk assessment of it should add value over time. There is a dedicated governance group (the Operating Committee) consisting of senior staff that oversees risk management.
An emphasis on liquid markets, proprietary risk models and a diversified funding structure are intended to make the process and outcomes robust. Citadel has achieved very good results over the long term partly through the judicious use of leverage. It is widely believed that Citadel’s flagship funds Kensington and Wellington employ much more leverage than a typical hedge fund. The use of leveraged exposure to markets makes risk control and portfolio construction much more important than they would be otherwise.
A dedicated risk management team
Operating independently of the investment businesses, and reporting to the CEO, the Portfolio Construction and Risk Group guides the allocation of risk capital. It is supported by a dedicated R&D team to create custom tools and technologies.
Under Chief Risk Officer Joanna Welsh the Portfolio Construction Group drives risk estimation and risk management across the firm. There is a small team of Risk Managers that each oversee a part of the business. For example Nancy Cheung, Head of Risk for Equities, oversees risk in all Fundamental, Quantitative, and Event-driven equity businesses. The Risk Managers are expected to be trusted partners to the senior leadership and portfolio managers and are responsible for identifying key risk exposures and performance drivers. The Risk Managers define and monitor the risk guidelines, and developing quantitative analytics to support risk estimation and management. In the Citadel risk framework a Risk Manager should play a critical role in positioning portfolios to be successful across a wide range of market conditions. They define and manage the risk frameworks for strategies and the trading desks, as well as the overall business. A key part of the job is to communicate risk information to Citadel’s portfolio managers.
Within individual business units Risk Analysts work closely with Risk Managers and Portfolio Managers to identify key risk exposures and performance drivers. So each of the fundamental equities businesses, Ashler Capital, Surveyor Capital and Citadel Global Equities have Risk Analysts embedded within them. Risk Analysts of the Portfolio Construction Group (PCG) are located in Hong Kong and London as the business requires.
The Risk Management Center
Citadel’s Risk Management Center provides a comprehensive view of the various investment portfolios and how they fit within pre-established guidelines. Built in 2014, its front-end consists of a 27’ by 8’ interactive touchscreen designed to visualize data in ways that allow for rapid comprehension. Its back-end systems, which connect to every Citadel office worldwide, continuously run a wide range of operational readiness, risk, and stress-test monitors.
“The risk centre is all about information, and our focus is on making sure the risk information is presented in a useful and impactful way,” says Citadel’s CRO, Joanna Welsh, who also carries the title of Head of Portfolio Construction and Risk Group. “Given the risk centre’s visualisation capabilities and the amount of data now available, we are able to assess the risk exposures of portfolio managers and market-makers more effectively, and we will continue to build on the current capabilities.” “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.
Welsh was hired by Citadel chief Ken Griffin last year to deploy a more dynamic style of risk management. Her appointment saw former CRO Alex Lurye moved to a new role as Chief Data Officer. There had been criticism that the stress-testing process at Citadel did not fully adjust to the extreme market conditions prevailing during the second half of 2008, which led to larger than expected losses at the flagship Kensington and Wellington funds. Looking at markets purely using past data as a guide has some dangers associated with it. Welsh terms it “the history trap”. Under Joanna Welsh’s stewardship the risk group has turned its attention to more accurately forecasting what could lie ahead.
The industry-standard approach of predicting volumes is based on previous days’ trading. For example, an equities long/short fund with monthly redemptions might focus on weekly and monthly (5-day and 25-day) measures of volumes of trading in shares they own/short. Average daily trading volumes are typically used as an input to transaction cost estimation and liquidity risk modelling. Citadel has recently moved beyond the look-back data window approach and has put together a new predictive model that takes into account effects from a set of market factors the firm has identified. This has led to a much better understanding of the flows that drive trading volume. This is a good example of work on one side of the firm (asset management) helping the other side of the business (securities trading and market-making). An example of a benefit flowing the other way would be real-time 3-D volatility surfaces derived from trading being used for risk assessment and control within asset management.
Citadel has taken initiatives to improve how it conducts stress-testing. Welsh wondered 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 analysis enables the firm to estimate risk for 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.
Reinforce the culture
A solid framework is important, but successful risk management is best accomplished when it becomes a central part of the portfolio manager’s analysis of potential trades and portfolio construction. The risk culture of Citadel is maintained and strengthened through continuous communication by the risk professionals, and those professionals work in collaboration with the investment teams to give an in-depth understanding of the portfolios.
How is Citadel on some of the soft issues? Well, like the rest of Citadel LLC the Portfolio Construction and Risk Group has a relatively flat organisational structure. Consequently staff members can do pretty much do the same thing for years at Citadel, despite changes in job title over time. This has productivity and cultural benefits in a function like risk management, but can be career limiting. Throughout the company the internal competition is structured so that everybody is ranked and rewarded on their ranking, which some claim makes Citadel a difficult place to work. There can be an issue in the hours worked. It is not uncommon for an 11-12 hour work-day, but that in itself is not unusual in finance. The tone is set from the top as, even to this point, Ken Griffin still goes to the office one day every weekend.
There are balancing items for those in risk management. The processes are constantly evolving/being-enhanced-at-the-margin through well-resourced research within the function. The atmosphere is said to be both academic and detail-oriented, which will suit many of those that find their way to a career in risk management. There is limited bureaucracy in Citadel, and a lot of opportunities to push limits of knowledge and to innovate. Those are attractive attributes for specific sorts of people.