Ari Bergmann, principal at Penso Advisors, answers SCI's questions

Q: How and when did Penso Advisors become involved in the business of systemic risk management?
A: Penso Advisors advises on systemic risk and manages tail hedging strategies for clients. The business was established at the beginning of 2010 because there was a realisation that systemic risk is here to stay. Systemic risk hit the market in 2008 and in 2009 people were hoping it was an aberration, but by 2010 they recognised that it is a reality that impacts all assets and geographies.

Hedge funds are experts at finding good idiosyncratic opportunities, but often get swept by the headwinds of systemic risk. We find ways of navigating those headwinds.

Our clients typically allocate between 50bp-200bp a year to insurance hedging costs. We help them understand - both quantitatively and qualitatively - what the sources of systemic risk are and how they affect their portfolios, structure strategies to combat them, then implement and monitor them.

Getting a view on timing is the most difficult aspect of managing systemic risk: it is important to act quickly, but not too quickly. Therefore, you have to implement strategies that allow you to wait without costing too much.

We always focus on simple, liquid strategies because they're usually the cheapest and most efficient. The creativity is in putting the building blocks together.

Execution depends on the client. Sometimes we execute for them via a managed account platform; other clients use their own balance sheets.

There are six of us in the team: a coo, general counsel, two traders, an assistant and myself. We conduct monthly meetings with clients to review their portfolios and their hedges, but we're available for consultations on a 24/7 basis.

Q: Which market constituent is your main client base?
A: Our clients include large hedge funds, fund of funds, family offices, insurance companies and pension funds. They are diversified across the US and Europe, and we're expanding into Asia.

We advise on approximately US$30bn of assets across 10 clients. We're mostly forward-looking in terms of their portfolios, but we advise on legacy assets too.

Q: How do you differentiate yourself from your competitors?
A: We're not aware of any other company that offers advisory and hedge management tailored to the needs of a client.

I have 20 years of experience in risk management and systemic risk - this experience is necessary to identify sources of systemic risk before they arise and then identify effective hedging strategies. The strategies need to be low-cost and have a leveraged upside - both of which aren't obviously captured.

We're seeing a new phenomenon spring out of the systemic environment: tail risk funds, which are essentially hedge funds that implement some kind of negative correlation to the market. They make money when a tail event occurs.

But the worse thing than not having a hedge is to have one that doesn't perform. If a hedge isn't tailored, it gives a false sense of protection.

Q: What are your key risk concerns today?
A: Our current focus in terms of sources of systemic risk is on sovereign debt and Europe. Potential future sources of systemic risk that aren't yet being focused on are: the deficits in Japan; US municipal debt issues; and the European countries not yet affected by the sovereign crisis - the so-called 'second-wave' countries, such as Italy and Eastern Europe.

The problem with systemic risk is that it affects everything, but the beauty of it is that if you hedge any part of the chain, the chain will react in the same way. It is possible to hedge the potential aftershocks of an event, for example.

Take the case of the subprime crisis of 2007: many people made money by hedging their mortgage exposure, but they also put a lot of money at risk by doing so. Instead of doing that, we bought protection on a basket of financial institutions - including Lehman Brothers - at an average cost of 30bp because we recognised that the aftershock from the subprime crisis would be with the banks due to their exposure to the sector.

After Lehman's bankruptcy, we exited our financial institutions hedge and hedged sovereigns because we recognised that the aftershock would lie with governments as they'd backstop the banks. At that time, protection on the UK cost 9bp, while protection on France cost 15bp.

The BIS viewed sovereign credits as riskless. Indeed, many participants failed to differentiate between European countries and the fragmentation caused by sovereign credit issues.

The European stress tests are overdue, but the question is: do stress tests adequately address future scenarios? For example, the US stress tests didn't uncover the problems that US banks face in the muni space. And the Euro stress tests wouldn't have picked up the sovereign issue if they were done six months ago.

Stress tests are only able to quantify existing stress points, not potential new stresses. This is why there is a need to be proactive about the risks out there.

Governments are notoriously reactive. Perhaps one solution to these issues would be to have a government think tank that identifies potential sources of risk and comes up with possible solutions before they become a problem.

Q: What major development do you need/expect from the market in the future?
A: The next crisis will be the aftershock of this one, but - unlike earthquakes, where the aftershock is typically lower in intensity - financial crises can gain momentum. Governments are currently trying to solve the problem by pumping liquidity, but liquidity doesn't mean solvency - it delays the problem and exacerbates it. It's like having an infection and only eradicating the symptoms but not the cause.

We're coming to the end of what I term a 'super debt cycle', where all of the leverage in the market needs to shrink to size. It has been and will continue to be a painful process.

The market is going through a paradigm change: we're emerging from a leveraged world that kept growing to one where leverage needs to decrease. In this new, less levered world, creativity and the selection of credits will be of upmost importance for structured credit products.

The market will have to come up with forward-thinking products, but this will give certain players the opportunity to differentiate themselves. Alpha rather than leverage is the order of the day.

Geography will also play a role. At present, there is a dichotomy between developed and emerging markets: the perception is that the developed world is less risky than emerging markets, but this needs to be challenged.

In reality, the developed world is overleveraged and emerging markets are underleveraged - meaning that there are plenty of opportunities to be had in emerging markets. The market could look back at what worked in the developed world and apply these lessons to emerging markets.

We're already seeing the first Yuan-denominated loans being structured, which suggests that the first commodity-based loans and securitisations aren't far behind. It's conceivable that a basket of commodities could form the basis of a securitisation rather than mortgages, for example.

CS