A top-tier asset manager quietly enters the risk management business.

By Robert Hunter

The company now known as BlackRock was created in 1988 by former First Boston mortgage-backed securities wizard Laurence Fink with a simple mission: to maximize its returns while minimizing its risk. While other buy-side firms were frantically scooping up the discounted detritus from the 1987 stock market crash, Fink set out on a different course. His company would proceed with caution, carefully tracking and analyzing every risk it took.

A dozen years later, this nonconformist approach has become commonplace, and BlackRock has catapulted to the upper reaches of the asset management universe, with $150 billion under its roof.

But asset management is only part of BlackRock's story.

Back in 1988, Fink sought to bring the risk management expertise of the sell side to the buy side, which was increasingly being confronted with ever-more-sophisticated financial products. "We made big investments in technology to give us the ability to understand securities as well as Wall Street firms, while at the same time being able to hold and manage portfolios,” says Bennett Golub, a managing director at BlackRock. "We wanted to be in a position to know our exposures and then to look carefully at the benchmarks we would be managing against, so we could make sure we were calibrating our active exposures to a level of realized volatility that was acceptable to our clients.”

"THE MINUTE you buy a software program and set it up on your desk, it could be out of date. Somebody's going to create a new type of index-amortizing note that the software's not going to understand.”

Managing director Joel Shaiman likens this approach to the football style known as three yards and a pile of dust—forsaking the long gains for steady, incremental progress. "We don't want to take a lot of inadvertent risks—we try to take the risks that we know the most about, or the ones that we have the best educated guess about, while not creating undue risk in other areas.” The formula: one part asset management, one part risk management.

BlackRock now divides its asset management services among three main types of clients: plan sponsors, mutual fund investors and insurance companies. The company is the second-largest asset manager for the insurance industry, and controls some $58 billion in various investment fund assets. Along the way, there haven't been many financial products that have avoided BlackRock's radar screen—and the company has put its broad product knowledge to use in novel ways.

The idea

In 1994, BlackRock began developing its second innovative business concept: selling its proprietary fixed-income risk management system to clients. Dealers and vendors, of course, had been doing this for years, but BlackRock was the first asset manager to enter the risk management arena. And it did so in spectacular fashion.

At the time, General Electric was in the process of selling Kidder Peabody to Paine Webber, but Paine Webber had balked at taking on Kidder's $10 billion collateralized mortgage obligation portfolio. GE Capital put the word out that it was dumping the positions, and Wall Street started submitting bids at significant discounts. BlackRock approached GE Capital with an alternative. "We told GE Capital that, given the fact that there was a great deal of turmoil in the market at the time, it wasn't the best time to sell off the whole portfolio,” says Shaiman. "We said, ‘Let us take the portfolio, model it in our systems, assist you in the hedging process and help you work out of the positions over a period of time. This way, you can show the market that you are not a distressed seller.'”

The deal, says Shaiman, was a home run for everyone involved. "Before long, we started coming across customers who told us, ‘We have the ability to buy and sell securities, but we don't have a risk management infrastructure comparable to yours. Is there some way you could run your numbers on our positions?'” BlackRock realized it was sitting on a gold mine of risk management expertise—harking back to the firm's massive technology buildup in the late 1980s—that it could offer to clients for a fee.

Now, half a decade later, the company sells its fixed-income risk management services to insurance companies, pension funds, real-estate investment trusts, commercial and mortgage banks, savings institutions, and government agencies. As of the third quarter of last year, BlackRock was risk-managing assets totaling more than $600 billion.

The product

Amazingly, BlackRock has thus far resisted the urge to attach a sexy name to its risk management service. Whatever you want to call it, the product is formidable: In its most basic form, BlackRock examines such risk parameters as duration, convexity, spread risk, liquidity, and sector and sub-sector exposures on a daily basis, and distributes reports to clients via secure web sites. But the company boasts that it covers the entire risk management spectrum—everything from advising clients over the telephone to writing term sheets for hedge contracts. BlackRock executives won't disclose how much they charge for their services, except to say they collect a fixed fee or a certain number of basis points against total managed assets.

The key to the product, says Golub, is its bottom-up approach. "Every fixed-income security has its own idiosyncratic elements. We came from a mentality that you need to know everything about a security if you're going to trade it, so we approach the risk management problem on a security-by-security basis. We analyze all the risks on each security—whether it is interest rates, spreads, volatility or prepayments—both individually and as part of the portfolio, rather than looking only at the sensitivity of asset classes in general.”

"WE approach risk management on a security-by-security basis, analyzing the risks individually and as part of the portfolio.”

BlackRock calculates dozens of different risk measures for every security it holds, and compares the characteristics of each portfolio to those of its relevant benchmark index. The risks are evaluated at the individual security level; can be grouped by asset type, portfolio, and external and internal managers; and can be viewed at the enterprise level as well. In addition, BlackRock offers compliance monitoring and regulatory reporting, various hedging services, and advisory services such as asset/liability consulting, portfolio review and restructuring, and portfolio liquidation.

The competition

Many other firms have tried to export their risk management expertise to clients, with varying degrees of success. Bankers Trust pioneered the concept with RAROC 2020, but that product hasn't lived up to its promise. JP Morgan has had more success with RiskMetrics, which it spun off into a separate company in 1998. Both of these products were created with mile-high Chinese walls in place to separate risk management developers from the goings-on in the trading room trenches. The result was often a disconnect between theory and practice, and between the cutting edge and yesterday's news.

"The broker-dealers are certainly capable in terms of knowledge, but don't have the infrastructure to do this day in and day out for a client, and potentially could have a bit of a conflict of interest in terms of advising in certain markets,” says Shaiman. "Because we are already in the business of holding thousands of securities in our portfolios, we can provide risk reports for clients who therefore don't have to be bothered with the overhead costs, the pain and the monotony.” And, he points out, clients can rest easy knowing that recommendations are based solely on the status of their portfolio, and not on a transactions-based fee.

The myriad plug-and-play vendor solutions, meanwhile, run the risk of being behind the cutting edge of new products being created and marketed, says Shaiman.

"The minute you buy a software program and set it up on your desk, it could be out of date,” he says. "Somebody's going to create a new type of index-amortizing note that the software's not going to understand, and it's going to be 12 months until you get the updated software to handle it. Because we support a $150 billion money manager, we know this happens every day, and we're ready for it.”

Indeed, the two biggest challenges in providing risk management services are the constant state of change in the financial world and the paramount need for quality. Most risk management systems deal with gaps in product coverage and market anomalies simply by faking it—by shoving data into the system any way they can. Golub scoffs at such practices. "You can't get around the need for judgment—someone's got to make an informed guess, and that person should know something about the markets.” In terms of the costs of sloppy errors, Golub's vehemence betrays his experience as a practitioner. "The difference between 99 percent accuracy and 100 percent accuracy is that if it's 100 percent right, you should use it. If it's 99 percent right, you don't know which day it is going to be wrong. If one number's wrong, credibility is lost and you can't expect people to take action based on the information.”

BlackRock avoids such problems by offering clients multiple ways to plug data into their system, from direct trade capture to e-mailing files and faxing trade tickets. When new products or unusual market conditions can't be modeled, BlackRock uses what it calls a portfolio management group approach. The traders responsible for the gaps are called on to provide shorthand fixes, and these temporary solutions are verified at the end of the month to make sure they were accurate. Such a dynamic approach, says Shaiman, sets BlackRock apart from its competitors.

Evidently BlackRock's clients agree. The company now has enough business to keep more than 150 people in its New York headquarters busily cleaning data, running risk reports and modeling securities. "This is a factory for the daily production of the highest quality of risk analytics we know how to produce,” says Golub. "It's not always glamorous—in fact, it's often highly tedious. But you never know which day a financial disaster is going to hit your portfolio.”