- Managing risk well begins with a high-level overview of one’s investment program, noting allocation across asset classes, and assessing the total program’s annual volatility.
- Across-the-board transparency is essential to evaluating a portfolio’s full exposure to risk. That means holding all fund managers accountable.
- Transparency and an effective risk management framework let an investor effectively combine both long-only and hedge fund strategies into a single integrated solution.
While investors can often see the risks taken by a fund or a single manager, or even within an asset class in their portfolio, many are not looking at the whole picture — they’re not identifying risks across their entire portfolio. But this total view, while sometimes difficult to bring into focus, is essential to managing risk.
“Most clients can see slices of risk, but they can’t see total program risk,” said Andrew Smith, chief investment officer of Client Solutions at Northern Trust. “They can see risk sliced vertically but not horizontally. We can help them identify the common risks taken among fixed income, equity and hedge fund managers. Are they doubling up on the same risks? We can help clients manage overall risk through total program risk analytics.”
Managing risk effectively begins with compiling data. Begin with a high-level overview of your investment program, noting the overall allocation across asset classes, and assess the total program’s annual volatility. “Then you can drill down and see where the volatility is coming from,” said Adam Magyar, Quantitative Strategist at 50 South Capital.
Understand What is Driving Risk
In addition to understanding how much volatility is attributed to equities and fixed income, knowing which managers contribute to risk — and how they are driving the risk — is paramount. More specifically, within equities, how much risk is coming from value or growth equities, small-cap or large-cap? Within fixed income, how much risk is coming from corporate bonds, government bonds, or shorter or longer durations? What geographies expose the portfolio to risk — and are there significant correlations to commodities such as gold or oil?
Having more complete data can help improve your ability to more thoroughly understand the investment managers, their exposure to risk and whether their risk profile is likely to be most helpful under certain market conditions. That in turn can guide asset allocation and risk allocation decisions — more effectively than relying on assumptions based on asset class risk expectations.
Having that information is just the tip of the iceberg. We use this data to see what happens to your portfolio’s risk level when you run your holding through an array of stress scenarios. Risk metrics include standard deviation, value at risk (VaR) and conditional VaR, the last of which focuses on what happens in the event of an occurrence outside the 99% probability range.
“Investors should ask themselves, ‘What happens in the event of a very unlikely occurrence, such as something that might have just a 1% or 0.5% chance of happening?’” Magyar said. “‘How much money could I lose? How comfortable am I with that?’”
Because risk exposure is dynamic and ever changing, risk management must encompass both a historical view and a current snapshot. How much volatility is normal for a fund based on its history? And how much risk is it currently exposed to?
We attempt to understand what is behind changes in managers’ risk exposure. If they are deliberately moving to a higher risk level, we ask, “Why now?” and track the movements and reasoning behind these portfolio decisions. This allows us to develop a deeper understanding of the way managers approach opportunities, think about risks and manage their portfolios.
Transparency: Holding All Managers Accountable
Across-the-board transparency is essential to evaluating a portfolio’s full exposure to risk. That means holding all fund managers accountable — those who manage long-only positions as well as hedge fund managers. Each manager’s risk exposure should be reviewed at least monthly.
While hedge fund managers are noted for being dynamic and using a greater spectrum of risk exposure, long-only managers can gradually and subtly shift their fund’s risk exposure. It could be as simple as a style shift. For example, a value fund incrementally takes more growth positions, evolving into more of a blended or growth style.
Close monitoring can help identify these shifts so there are no surprises. “We need to see changes in risk exposure as quickly as possible,” Magyar noted. “That means keeping our fingers on the pulse of all managers.” In addition to monitoring fund positions monthly, the investment team meets each week to share observations and insights.
In monitoring hedge funds, it is important to closely track their performance and positioning, but also to allow them enough freedom to capture returns and appropriately position the fund, given shifting economic and market conditions and opportunities. We try to maintain a balance between monthly monitoring and proactive risk management while taking a 12- to 18-month view.
Optimal Use of Long-Only and Hedge Fund Managers
Transparency and an effective risk management framework enable the investor to effectively combine both long-only and hedge fund strategies into a single integrated solution. Insight into each fund’s risk exposures allows the investor to select managers who strategically complement one another. Ongoing monitoring of these exposures allows the investor to effectively assess risk and manage a diverse group of funds by having the ability to make informed and impactful decisions as market conditions change.
Managing Volatility: What To Do With Risk Reporting’s Many Numbers
Generally people refer to all matters of risk as “risk management.” This is a misnomer as risk management encompasses a lot more than running complicated and technical analysis of your investment program. Oftentimes when people refer to risk management, they are actually referring to risk measurement.
But risk measurement is only the first step in risk management. Managing risk entails taking what you know and then doing something about it.
A custom hedge fund program that incorporates detailed transparency and sophisticated risk analysis can be an effective tool for managing risk. Hedge funds are not just a classification of investments. There are several hedge funds, and hedge fund managers, that can target specific risks and sectors of the market. This makes a hedge fund program highly customizable, making it possible to uniquely tailor a strategy to meet an investor’s specific needs.
Hedge fund managers typically have greater flexibility in how they position their funds, so it is optimal to put that to full use when it can make the greatest impact. Conversely, because hedge funds have higher expenses, it would be unwise to overspend on them in a situation where your managers might expect to earn returns that only keep pace with the market.
Having more complete and thorough data on each manager can lead to better and more granular analysis, an improved understanding of each manager’s strengths and weaknesses and a better sense of where a given manager is more likely to outperform. “Knowing that can help you select the best managers for a variety of situations,” Magyar said.
Scenario Analysis: Preparing for Possible Outcomes
Knowing your portfolio’s current exposure is an important start, but understanding what might happen in a variety of possible risky scenarios could make a crucial difference. Scenario analysis begins with identifying your portfolio’s sources of risk and determining how it might react in a range of possible events. For example, what if a member country defaults on its credit and leaves the eurozone? What if a European country’s government or economy collapses?
In each scenario, data are used to predict how the market might behave and how a particular portfolio might respond. This analysis could be based on historical data, indicating what occurred during stressful events, such as the 2008 financial crisis. Alternatively, a model could be constructed in which a number of risk factors are assumed.
Looking at various scenarios, consider the likelihood of a particular scenario occurring and how well positioned a portfolio is for the related risks. In analyzing the economic and market outlook, for example, you might assign a 60% probability of slow growth, a 20% chance of a strong economic recovery and accompanying positive financial market performance, and a 20% chance of a severe downturn. Examine all three scenarios and assess how much portfolio risk to take given the assessment of the various probabilities. This process helps us to understand the most effective risk allocation approach in light of the various scenarios and the potential consequences associated with each scenario.
It’s not a question of insulating a portfolio from risk, but rather allocating risk in the most effective manner for your portfolio’s investment mandate. Where are you going to get the highest return given the probabilities of — and the consequences associated with — each of those scenarios?
Better Information, Better Insight
The objective of these detailed scenario analyses and stress-testing exercises is to avoid unpleasant surprises by being prepared and aware of the total risk your portfolio faces. Having the information, and being able to act on it in an effective and timely manner, is key. Total portfolio risk analysis tools are essential, as is the experience to manage the tools and leverage the insights gained.
Dynamic Risks Require Greater Focus
Risk once was considered static. Now it is widely understood to be dynamic and reflective of changing market trends and shifts within a manager’s holdings as well as the strategic and tactical positioning of the entire portfolio.
“Investors now realize that risk is always changing, and they need to stay on top of it,” Smith said. “Asset allocation is becoming risk allocation. As investors start to realize that, they have greater appreciation for making informed decisions based on comprehensive risk data and risk analysis support.”
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