Understanding Risk
The story goes that in 1986 Larry Fink, the shooting star in the mortgage department at First Boston, put a trade in expecting the interest rates to rise. Instead, they did the opposite. Fink lost the firm $100 million, and in the process he lost his job, too. He had joined First Boston as a graduate trainee, and his talent and abilities propelled him forward, and he was expected to make CEO. He was one of the brightest, tso how did he make such a fatal mistake, leaving his position uncovered? It turned out that it wasn’t his mistake. His back office, the nervous system of any operation, made a catastrophic error. We find the explanation deep in one of the most recommended books in the industry, What It Takes, by Stephen Schwarzman: “But a guy from the back office who ran Larry’s computer models had made a mistake, and the hedges were wrong. Larry had made his calculations based on the wrong numbers. In a single quarter, his department lost $100 million. It wasn’t his fault; he didn’t control the back office.”
Fink lost his job and must have left with a long-lasting memory and a drive, which some still call a “neurosis,” to have precise risk-management tools to measure and manage risk in portfolios. Two years later, in 1988, just before the Berlin Wall collapsed in Europe, he opened BlackRock in a modest office in New York. BlackRock’s first employee, Charles S. Hallac, was to take the lead on Fink’s fixation and start building Aladdin, the acronym for Asset, Liability, Debt, and Derivative Investment Network. Hallac remained with BlackRock for his entire career and eventually became the co-president. Throughout his entire career, his agenda was to make Fink’s vision work: to build and own a robust risk capability that would provide a comprehensive risk overview of a firm’s portfolio and be fully integrated with the investment process.
Understanding Aladdin
“To really understand BlackRock, you need to understand Aladdin,” says chief operating officer Rob Goldstein, who oversees Aladdin as head of BlackRock Solutions. “In the earliest days of BlackRock—almost from day one—the firm was very focused on building this risk capability to understand each and every asset, each and every benchmark, and each and every portfolio.”
Goldstein joined BlackRock as an analyst in 1994, which was dubbed the Great Bond Massacre year, as the Fed began raising interest rates more than the markets expected. Fixed-income portfolios blew up amid rising interest rates and shrinking bond prices. In this volatile environment, the risk analytics built as Aladdin revealed its value. BlackRock’s funds held up well and had minimal loss compared to the overall market. Aladdin enabled BlackRock investment teams to understand what they had bought. The market took note, and people started to call BlackRock, asking them to “take a look at their portfolio.” This was the first instance that showed BlackRock they had built something their competitors didn’t have. Although the level of technical sophistication was not that high, according to Rob Goldstein, “you were a highly technical person if you knew how to use Lotus 123.” In mid-1990, BlackRock already “had the capability to capture trades electronically, to have dashboards with different colours to manage the work flow digitally, to have all positions in real time. That was shockingly rare at that time.” In the midst of 1995 crisis, BlackRock quickly understood that the technology that they developed and that they thought others might have, was actually “quite unique in the industry at that time.”
Goldstein candidly recalls the epiphany they had when they realised that they could sell this technology to third parties. It was on Halloween 1994, when they received a call from Kidder Peaboddy, the brokerage subsidiary of General Electric, asking BlackRock to help them value its assets by looking at the data on a disc called the “Michelle Spreadsheet,” with more than 1,000 rows of trades. As they would perform the trades, they would shout at Michelle (an employee at Kidder Peaboddy), who would input those trades in her spreadsheet.
Aladdin was originally designed as a piece of tech to analyse risk. In time, it has evolved into an embedded enterprise system that supports a wide range of business processes like a central nervous system of the enterprise.
BlackRock’s Phenomenal Growth
In 2020 BlackRock is an asset-management colossus, managing more than $7.7 trillion. This is the story of phenomenal growth, supported by a sound technology core and a few carefully selected acquisitions like the following:
Merrill Lynch Investment Managers in 2006, which took them into the European equities.
Barclays Global Investor in 2009. BlackRock paid $13.5 billion for BGI. The acquisition doubled BlackRock’s assets and helped BlackRock set a firm foot into the ETF market, as BGI owned iShares, the biggest name in exchange-traded funds (ETFs), a rapidly growing $1.4 trillion industry. This acquisition prompted The Economist to comment that “The firm's girth also threatens to attract the gaze of regulators.”
eFront acquired for a reported $1.3 billion, giving BlackRock an entry into alternative investment management.
Aladdin not only protected BlackRock's own portfolios by flagging systemic risks in 2008 but also provided a unique opportunity to answer one of the federal government’s most ardent needs—to evaluate the risk exposure in the banks’ portfolios. Banks called BlackRock to evaluate their portfolios, and Aladdin was used by the Fed, the banks, and the Treasury. This boosted Aladdin’s portfolio of clients to a total of $7 trillion of assets under management in 2008. While the world was melting down, Aladdin was rising above it all. Aladdin kept on growing and adding more institutional clients and became the point of call during financial crises. JP Morgan started using Aladdin and paid a reported $1.5 million for integration and the annual fee, which kept growing to $5.3 million.
Since 2017, BlackRock has stopped reporting Aladdin’s assets under management and number of clients. As the broader stock-picking business has come under pressure from lower cost index funds, BlackRock’s CEO aims to derive 30 percent of revenues from technology services by 2022, namely Aladdin. It is estimated that Aladdin has in effect about 10 percent of the world’s financial assets.
Meet Aladdin
This is one of the most comprehensive end-to-end portfolio management softwares. Aladdin’s website states that Aladdin monitors 2,000+ risk factors each day—from interest rates to currencies—and performs 5,000 portfolio stress tests and 180 million option-adjusted calculations each week; it assesses hundreds of risk and exposures metrics to create tailored reports and graphics, based on a client’s specific needs and preferences. Aladdin and Aladdin Wealth are relied on by approximately 55,000 investment professionals around the world. Aladdin Wealth has made a much-needed entry into wealth management with a hard-to-resist proposition. They have started attracting wealth clients like Morgan Stanley and HSBC, which will offer this technology primarily for clients with more than $1,000,000 in their portfolio. Aladdin claims that it provides tools to help organisations communicate effectively, address problems quickly, and make informed decisions at every step of the investment process.
Aladdin is BlackRock’s proprietary technology, owned and controlled by them, and is delivered as a hosted service, including the Aladdin technical infrastructure, system administration, and interface with data providers and industry utilities. Aladdin is sticky and complex to enter and exit, making it the go to software.
Industry Domination
In 2013, The Economist set their gaze on BlackRock and called it “the monolith”. They focused on Aladdin and pondered, “Getting $15 trillion in assets on to a single risk-management system is a huge achievement. Is it also a worrying one?” Its reach extends further: to corporate bonds, sovereign debt, commodities, hedge funds, and beyond. It is easily the biggest investor in the world, with $4.1 trillion of directly controlled assets (almost as much as all private-equity and hedge funds put together) and another $11 trillion it oversees through its trading platform, Aladdin (see article). In 2019, Aladdin’s business model made the subject of the landmark case BlackRock Investment Management (UK) Ltd v HMRC on VAT treatment of technology platforms’ fees.
Aladdin counts as its clients non-financial institutions as well. It is now used by Apple, Microsoft, and Alphabet for their corporate treasury investment portfolios. Aladdin has built a client base and has become the default option of the marketplace. The Financial Times estimates that over “$21 trillion sit on the platform from just a third of its 240 clients.” The influence is more than just money. “If you are looking to buy anything, or sell anything, or invest anything, it’s very difficult to get around BlackRock,” says the boss of a large European insurer. BlackRock knows almost everything.
This much money brings a range of concerns. More than 17,000 traders in banks, insurance companies, sovereign-wealth funds, and others rely in part on BlackRock’s analytical models to guide their investing. These people, overseeing many of the world’s largest pools of money, are fall at least partly relying on BlackRock’s analytical models to guide their investing. This begs the question as to how much systemic risk this influence may cause in the market. If everyone is using the same risk-assessment, then they see the same risks framed in the same way and none of the blind spots. “There’s no way you can get the same understanding of risk if you developed the capability in-house, versus getting it off the shelf,” says an investment manager at a $500 billion-plus fund, which looked at implementing Aladdin.
This groupthink was cited as the reason why Los Angeles County Employees’ Retirement Association’s $58-billion pension fund decided against using Aladdin. A by-product of groupthink is possibly a less healthy market—there is no judgment in decisions if everyone is part of the same ecosystem, which might translate in a reduced alpha, with a smaller upside when it gets things right and deeper downside when it gets them wrong.
Another major concern is cybersecurity—a centralised point of so much financial data can become a desirable target for cyberattacks. Additionally, if everyone buys third-party risk analytics, then they have no incentive to build their own. A further concern is getting off Aladdin, which is hugely complex and costly, making it almost impossible for its clients leave. Finally, BlackRock is the largest investor in companies that use Aladdin, and a range of possible conflicts of interest have been flagged, in addition to a cross-pollination of board director positions across the boards of Blackrock, some of Aladdin’s clients, and that of companies in which BlackRock invested.
The Financial Times posits that “the world’s most powerful risk-management system threatens to become a liability for its owner.” With so much money comes a lot of influence. And we have to give it to Larry Fink for publicly starting the Environmental, Social and Governance (ESG) agenda. In January 2020, he wrote an open letter to the industry, adopting a strong stance on climate change by supporting sustainable investing, through divesting investments in certain fossil fuels or using its votes at annual meetings to highlight misalignment of purpose.
Modern Finance
Aladdin is getting better with each use and continues to attract more clients. Its technology delivers, and it provides an unique guide and insight in turbulent times like the current pandemic.
BlackRock continues to invest in the frontier of modern finance through their systematic active equities (SAE) arm; their San Francisco-based $100 billion AI quantitative investment unit has recently become more critical to BlackRock’s operations, demonstrating that they can beat the market consistently, irrespective of conditions. The SAE team creates a variety of signals that work together to buy or sell a stock. They use alternative data like geolocation capabilities and also consumer activity to identify sentiment and fundamental decisions on stocks.
BlackRock’s foray into the innovative deployment of AI will most likely continue. It will continue to build for them a competitive edge which will be extremely hard to match by their competitors. BlackRock are tech pioneers. They are probably the first fintech ever, when the fintech concept wasn’t even in our vocabulary. Being tech pioneers has always delivered value to them, it has always give them a special status. BlackRock’s Aladdin is a business case for boards to reflect on, should they ever want to see an evidence of what technology leadership means.
The Genius that Is Larry Fink - Lessons for Financial Boards
Aladdin is a 32-year-old fintech that has grown out of Larry Fink’s healthy fixation to know and manage risk. He had the vision to use technology to deliver it. His fixation was based on what he regarded as a necessity ‘to know your risk’; and yet, at the time, the rest of the industry didn’t seem to identify the same necessity and build their own technology. I think Larry Fink is a true visionary and a very successful one; he is possibly the most important man in finance right now. Success of this magnitude always attracts critics, and Larry Fink is not short of critics.
However, no one can deny his prescient vision and the business value, clout, and unparalleled industry knowledge that his vision has delivered for BlackRock and its shareholders. No one can also deny his ability to raise out of the ashes of being fired and finger pointed as persona non grata on Wall Street after losing $165 million (adjusted for inflation to 2020). Those who work in finance, know what persona non grata really means especially in the 1990s: it’s a career death sentence. Larry Fink refers to it as a “life shaping event”, which no doubt brings in one trauma and determination, in equal measures. A Wall Street banker helps us better understand Larry Fink’s predicament “Larry worked very hard to repaint himself. When you are fired, there is a drive to redeem yourself, to prove yourself, to show people that you have the goods. I think that is a lot of what motivates Larry. Without him, BlackRock would just be another big asset-management company. But Larry has put it in center ring.” About two decades later, in the midst of the subprime mortgage meltdown in 2007, Larry Fink was on Wall Street’s speed dial: the most sought after option and expertise.
There are many leadership lessons board directors to learn from following Larry Fink’s career. He is an incredibly smart financier, who (while lifting himself from a dead-end point in his career) saw the value of technology when everyone else in the industry was oblivious to it. Larry Fink understood how to use technology as a strategic business tool to further his company and better its investment outcomes. It was a stroke of genius. As a contrarian, I appreciate those people who see value in places where others don’t think there is any.
As an art collector, I am always interested in people’s art choices, so I found out that Larry Fink collects American folk art. Weather vanes, are decorative yet useful pieces placed at the top of buildings. They have arrows that point in the direction the wind is coming from. For centuries, they have kept people informed of the elements, signalling meteorological events likely to impact people’s lives, safety, and well being. They have been used as risk prediction tools, if you will. Building weather vanes combines chemistry, biology and a special hand craft. Larry Fink also collects weather vanes which is rather suitable for a portfolio manager—a meteorologist for investments.
Copyright Clara Durodié, October 2020. All rights reserved.
Written by
Clara Durodié
The views expressed in this article are those of the author alone and they are not of Cognitive Finance Group.
Ethics disclosure
Cognitive Finance Group is not an adviser to BlackRock. Clara Durodié doesn’t own shares in BlackRock.
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