I walk slowly, but I never walk backwards. Have you moved forward with your risk awareness?

The internet is a huge and seemingly all-knowledgeable place sometimes. When I went looking for a quote using the word "slowly," I not only found the the above by American President Abraham Lincoln, but also a whole 45 minutes-worth of other interesting reading from a huge breadth of people and eras, including this famous and rather apt line from Charles MacKay:

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

There was a consistency in many of the quotes, including these two, underlining the recognition that learning and acceptance can be a slow process which panic and ignorance can quickly offset, but that it is one that we must all stay committed to.

What topic is it that brings me to this introduction? That it is now one year since we saw the huge downward movements in the markets, I want to summarise and comment on what I have seen in terms of change in portfolio risk management over those last 12 months.

Risk Model Providers
Many of the risk models that people were using took some criticism in October/November last year as their models were considered to be slow to react. This in turn lead to the emergence of shorter horizon models (R-squared, Barra, Northfield, etc.) and practitioners were encouraged not to replace their current models, but to complement them with the additional analysis that could now be generated. This parallel analysis can give confidence in markets where the horizons are shifting.

Modelling Techniques
Stress-testing is another complementary analysis technique that got plenty of air-time (not least in this blog) as people have looked to forecast the impact on portfolios of certain market changing events, both historical (e.g., Internet bubble, Rouble crisis) and modeled (e.g., Oil to $200). There has also been work on the incorporation of "fat-tails" into the forecasting models and how they can directly affect the outcome of tests such as the commonly-used 10 day 99% VaR limit. Monte Carlo techniques for analysis of the whole distribution now give us further measure such as Expected Tail Loss and CVaR.

Attribution
When AUM has fallen by >40% it can come across as a little disingenuous to point out that a portfolio outperformed its benchmark by a few points and attribution was probably not the tool at the forefront of people's minds. The subsequent rally experienced since April has however brought it back to centre stage, and the ability to combine risk attribution with the more customary allocation-based methodologies (e.g., Brinson) for both contrast and measurement continues to win approval.

Third Party Commentary
There has been much conjecture following on from last year regarding what, if any, new regulation will be implemented. The criticism of VaR, or at least the over-reliance on it as a single risk measure, was just one high profile area of discussion. The need to improve the granularity, frequency, and depth of reporting is another. The Tower Group recently published a report on risk analysis budgeting in the industry (a summary of which can be heard here) highlighting the expectation of all participants that an increase is on the cards. They report that they expect budgets of IT spend as a whole to remain fairly flat but that the allocation of those budgets towards the understanding of risk will rise markedly.

Summary
So what have we been seeing with our clients? The drop in the market from September last year brought a reduction in AUM which, not surprisingly, was seen in reduced fees and therefore a reluctance to commit to new risk spending. There has been a large amount of general interest picking up in the new models and new implementation techniques. We have seen some clients embrace new analysis and reporting for their business units combining several of the above points. But most are undecided and unwilling to commit to change, perhaps balancing the recognition that things have to change with demanding investment into an area seen as a necessary evil rather than the necessary toolset that I believe risk analysis to be.

What are you doing? Which direction do you believe improvement in risk awareness will come from? Are you moving forward? In the financial landscape of the moment there seem to be two major players, and as I started with a quote from an American about always looking to progress, I will finish with one from a Chinese man, Confucius:

"It does not matter how slowly you go as long as you do not stop."

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