By Andrew Rogers, The Gemini Companies
There are many different methods to calculate and monitor portfolio risk. However, many believe that the best approach starts with, and is generally driven by, the philosophy and requirements of the investor within the context of the investment mandate and portfolio goals. Effective risk management therefore combines a rigorous due diligence process with the establishment of investment guidelines, and leads to the definition and implementation of risk policies and procedures. From there, it then evolves to a continuous monitoring of exposures using a variety of advanced risk metrics and strategies.
Thorough due diligence is a prerequisite for any effective portfolio risk management process, and a full quantitative analysis of the track record is an important first step. In a relatively recent development, we have seen trading advisors greatly increase their data transparency and are generally happy to provide information on returns, holdings, allocations and historical margining. These data points can be used to determine information about volatility, historical drawdowns, correlations to benchmarks, return distributions, etc., and serves a dual purpose—to fact-check the manager-provided metrics as well as to provide a framework for additional research. Trading advisors can provide this information to investors to fill in any gaps about a specific investment strategy, how risk is managed internally, and the operational framework for doing so.
In this way, a strong understanding of the investment process allows investment risk to be both understood and managed on an ongoing basis. As part of their continual risk-management monitoring, investors should, at a minimum, be able to confirm that the trading advisor is adhering to their stated investment and risk guidelines. This involves monitoring the portfolio to make sure that mandates are not being broken with regard to the size of positions and the markets that are traded. While this measure is necessary for good governance, this is especially important to avoid any unforeseen concentration risk, liquidity risk, and geographical risk. Additionally, ensuring that a portfolio is properly liquid and diversified, a prerequisite for the efficacy of standard risk metrics, also generally allows investors and advisors to better manage extreme, or “tail,” risk events.
Among the most common risk analytics applied to portfolios are variants of Value-at-Risk (VaR) calculations as well as stress-testing. Interestingly, the strength of VaR is also its weakness—while effective at calculating potential losses at a given confidence interval, VaR does not forecast the magnitude of losses in periods of tail risk.
Stress-testing with both custom and historical scenarios can partially fill this gap, but they are only as strong as the scenario being presented. By their nature, no two financial crises are ever identical, with the resulting correlations between markets being difficult to predict. In those cases, the explanatory power of both Monte Carlo and discrete event stress-test models can generally be limited.
Therefore, while VaR statistics and mathematical modeling can be useful, many believe a robust approach towards risk management should include an overall-exposure-based strategy. This allows for the forecasting and management of actual losses when correlations between markets and asset classes diverge from their modeled or historical patterns.
It is for these reasons that we see many top trading advisors employ this type of proactive methodology. They combine traditional risk strategies with limits on exposures to markets and asset classes, as well as a top-down portfolio-level view of risk. When trading advisors set and adhere to comprehensive risk management policies and procedures that augment this approach, they can generally implement a sensible way to both forecast and manage losses in multi-standard deviation events—and provide a strong framework with the potential for total returns consistent with mitigating potential losses, thereby benefiting investors as well as their firms and strategies.