The Efficient Process Frontier

The efficient frontier is defined as “… the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.”

In the same fashion, processes inherently have a risk v. value calculation

The “Efficient Process Frontier” is the set of optimal processes that offer the highest expected value for defined level of risk or the lowest risk for a given level of expected value

In applying the concept of “efficient frontier” to operational processes, we need to define the risk and return our “portfolio” of operational processes

The “Risk” of an operational process is a combination of the dispersion of the timing, process steps, manual intervention, accuracy and finally, success of a process relative to the mean of those values. In effect, it is the standard deviation to the measurements of not just the success of the process but its attendant sub-processes, accuracy and timing. The “Risk” of processes may be weighted differently based on time, number of steps, overall success based on their inherent value to the firm

The Return of an operational process is determined by its overall value to business of the firm; namely, providing investor value in terms of investment return, risk and transparency.

The efficient frontier of any operational process is the set of optimal processes that offer the most business value with the lowest the lowest risk as weighted for timing, steps or accuracy.

Operational Processes with an efficient process frontier can range from Compliance and Portfolio Risk to Trading and Accounting.

The typical end of day Profit and Loss reported by the operations group of an asset manager to the Portfolio Manager demonstrates the risk v. value tradeoff.

For example, the risk in this context might be a combination of the risk of inaccuracy of the report  v. the reward to the portfolio manager in being able to see timely information. Timeliness, accuracy and value are all elements of the efficient process frontier equation. Does the Profit and Loss tolerance need to be less than 1-basis point? 5-basis points? How much longer does it take to verify the end of day Profit and Loss for a 1-basis point difference v. a 5-basis point difference? These are questions that the efficient process frontier can answer. At Ryan, we have developed a unique formula to answer these questions and provide the optimal efficient process frontier for any process.

Operational Processes as an Asset Type

Operational Processes and Operational Efficiency have been likened to any other asset that a firm purchases. For instance, the “Return on Investment” of operational processes is freely bandied about as if processes are like any other asset. In another example, “Process Mining” likens the artifacts of any process, it’s audit trail, to the ore of a precious metal. However, it’s viewed, it makes sense to think of these operational processes as assets in the asset manager’s portfolio; With any asset, there is a cost involved and overhead to ensuring that the investment delivers the return expected. What has been woefully lacking though, is the application of investment management discipline to the “asset” of operational processes. Most frameworks for operational efficiency come from industrial analogies. This means that as a company, the investment manager, is saddled with a view of their firm that applies to much larger firms that have, at best, a view of investments limited to the production of a good or the delivery of a service or a mining operation.

 Asset Managers, and especially hedge funds, like their investors, are much more opportunistic. They may enter into special investments or deals that last only for a month or two. Each of these special deals may require different processes to ensure the proper measurement of the investment’s return as well as any inherent compliance or trade related requirements.

 Asset Managers are best served by viewing their internal and external processes as simply a portfolio of assets each with different purposes. They should evaluate that portfolio of operational processes as they do any asset. For example, it’s not enough to evaluate the “Return on Investment”; instead they should ask the same questions as they do of any other investment in their portfolio.

1.       What is the cost of the operational process?

2.       What is the expected rate of return? How does the Operational Process deliver return?

3.       What is the performance of the operational process? How do you measure the performance of the process?

4.       What is the volatility of operational process?

5.       What is the dispersion of the operational process if  the same processes are repeated across multiple areas?

6.       What are the operational processes hedging costs? What are its financing costs?

7.       How are operational processes correlated with other processes?

8.       What is the risk-free return of any operational process?

 The investment management industry method for evaluating a portfolio of investments is far more sophisticated than any large industrial company, applying some of these concepts to their operational processes yields better application of t