2009 Year in Review

A collection of year-end summaries from our bloggers.

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It was a busy year using new media to share current risk topics in various formats with our clients. We first launched our new risk website at the start of the year to house all of our new content. The site provides comprehensive information on our full suite of risk products including a recorded web demo of our risk workflow and links to our risk blog, podcasts, and white papers.

The blog and podcasts were a new direction for us this year and we received a very strong response from our clients about sharing current information via these new media. We blogged or podcasted on many of the most relevant risk issues this year including:

• the Madoff scandal with Dan diBartolomeo (podcast)
• the contribution of model failure to the financial crisis with Emanuel Derman (podcast)
• the challenges of post-2008 risk modeling with Frank Nielsen (podcast)
• a comparison of different risk model providers (eBook)
• numerous commentaries on appropriately incorporating VaR analysis and Stress Testing into every day risk management practices

We hoped you enjoyed the new forms of information sharing from us this year and we look forward to expanding in this area in 2010.

Rick Barrett

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When thinking about the items and events of significance that occurred during the past year, it's hard to look past the Global Financial Crisis itself. In many ways, 2009 has been a rough year as a result of the pain caused by the GFC and the ensuing so-called Great Recession. There are lots of negatives that people can and have discussed, but, if possible, I would like to put some positive spin on the GFC from the perspective of risk management. Prior to the start of the GFC, my experience in working for a company that supplies risk systems and models was more often than not one that could be characterized by a statement much like the abbreviated one I have created below.

Investment Firm Employee: "I do not necessarily have an opinion about risk estimation or risk modeling, and I do not even believe it is really relevant to our investing approach because we do x, y, and z. But the fact of the matter is that we need a system that can provide some basic risk information about our portfolio(s) to satisfy [government regulation/new mandate/prospects/clients, etc]."

The important thing to take away from the above statement is that for many investment firms risk management was clearly not part of the investment process and was really just a tick box in an RFP or something to include in a marketing report. Since the GFC, many firms have come to the realization that risk management should play a much more important role in the investment process. Firms are now taking the time to ask meaningful and relevant questions when contemplating risk systems and risk model providers. They are hiring people to not only monitor risk, but actually to provide feedback into the firm's investment process. In other words, risk management is finally beginning to live up to its name and becoming an integral part of many investment firms' portfolio management processes.

We are always taught in finance that investing is about the risk-return tradeoff. I think that 2009 and the GFC should be remembered as the wake-up call that forcefully reminded people of this relationship and that you cannot focus all of your energy on one part of it and totally neglect the other.

Andrew Kovaks

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"But she must have a prize herself, you know," said the Mouse.

"Of course,"the Dodo replied very gravely. "What else have you got in your pocket?" he went on, turning to Alice.

"Only a thimble," said Alice sadly.

"Hand it over here," said the Dodo.

Then they all crowded round her once more, while the Dodo solemnly presented the thimble, saying "We beg your acceptance of this elegant thimble"; and, when it had finished this short speech, they all cheered.

- Lewis Carrol, Alice in Wonderland

When summarizing 2009 and looking ahead to the next decade, there is one person without whom no discussion of risk can take place: Ben Bernanke, the Time magazine Person of the Year 2009. He is no longer a firefighter that quickly steps in to put out a fire, he is a one-man committee to bring the prosperity back.

As Time put it:

"... He conjured up trillions of new dollars and blasted them into the economy; engineered massive public rescues of failing private companies; ratcheted down interest rates to zero; … blew up the Fed's balance sheet to three times its previous size; and generally transformed the staid arena of central banking into a stage for desperate improvisation."

It is certain that the events today will shape the financial landscape for years and decades to come. Will Ben Bernanke be able to put the world economy back on track and what do his actions mean for risk professionals? Firstly, I do not think that it is possible to create long-term prosperity by borrowing and printing money; otherwise every nation in the world would be rich (except those without credit and color printers, of course). The last person who “saved” the world economy in this manner was Alan Greenspan, who lowered the real interest rate to zero in 2003 and kept it there until the economy appeared to revive. This solidified his oracle status and this financial maestro was even able to quietly slip off off his pedestal into the private life before the financial dumbbells he threw up in the air (in the form of zero interest rates) started landing on the heads of the largely unsuspecting public. Creating growth with free money (read: leverage) inevitably leads to the events we know as Black Swans. Bringing liquidity to stop liquidity crisis is one thing, but what we are witnessing is far beyond that.

Why, you might ask, such a gloomy assessment for my 2009 year in review? Well, there are certainly happier things to write about, but none more relevant to the risk manager. Besides, risk managers have it within their power to help the public and other investment professionals understand why events once known as once-in-a-lifetime Black Swan occurrences are becoming as common as black cats in a pet store.

The transfer of the financial system leverage onto the shoulders of the US currency is going to demand much vigilance and alertness from the risk managers in 2010 and for years to come. Risk management will become more and more crucial to any investment firm, and this will also place a burden on the risk software providers to be less dogmatic and understand that the landscape is changing.

Risk management has been rising in importance over the past decade, though I think it hasn’t yet become important enough to actually affect the course of events, only to interprete them. I hope that the next decade changes the second part of that statement.

Happy Holidays!

Daniel Satchkov

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Lessons learnt from a roller coaster decade

It’s the time of year where many people look on the year that was, what happened, why things happened, and what we can learn and wonder what will the future hold. As it’s also the end of a decade, I thought I’d have a quick look at the past decade in risk terms.

If you invested in any developed market index at the beginning of the decade, went to the moon or some desert island and came back this week, you would’ve found that the amount in your nest egg has gone down by a few percent. You could be forgiven for thinking not much happened in the past decade. Anyone who has been around will know this is far from what actually happened. The S&P 500 rose a few percent, fell 40%, rose 100%, fell 50%, and then recently rose 50% again over the decade to end down those few percent.

Long-Term Volatility

Similar to index levels over the decade, long-term levels of volatility haven’t changed much. The three-year standard deviation of the S&P 500 was 19 in 2001. While volatility dipped in the middle of the decade, levels currently are at 20. So long-term volatility is at levels seen a few times in recent history.

Short-Term Volatility

Short term volatility is telling a different story. Using the VIX as a proxy for short-term volatility in the S&P 500, short-term volatility hit an all-time high at the end of 2008 following the credit crisis and Lehman’s bankruptcy. This was at levels double what had been seen before. While levels have returned to more “normal” levels, recent highs are still on many investors’ minds.

Risk in the Industry

For various reasons, risk has become a more frequently used term within the investment community. Recent short-term events have had a big impact on fund managers and their day-to-day decision making. Investors are asking for more and more transparency from their fund managers. One aspect of this is risk analysis so they can better manage their risk-adjusted returns. The credit crisis, Madoff scandal, Lehman bankruptcy, and other events have contributed to greater oversight from governments and regulatory authorities. Tracking Error and VaR numbers are more frequently showing up in client reports. Everyone in the industry now knows that not all swans are white.

Has this increased emphasis on risk had an impact on portfolios? It appears so. While the level of volatility in the markets is slightly higher than levels seen at the beginning of the decade, average tracking errors appear to have decreased. Consider the Morningstar U.S. Large Cap Blend peer group. Looking at the tracking error of the quartiles over time, we see that the market volatility is slightly higher than it was at the beginning of the decade.

Relative risk by quartiles is actually down. Looking at the below chart, you will see that the 25th and 50th percentile tracking error decreases from about 8 and 6 earlier in the decade, to 5 and 4 more recently. Roughly 35% decreases in relative risk with market risk up slightly. Arguments can be made if this is due to better risk management or due to managers simply becoming more passive. But it does appear that increased risk management is having an impact.

Realized Tracking Error of U.S. Large Cap Quartiles

Future

What does the next decade have in store for us? The past decade was a roller coaster ride, only to return more or less at the start. I won’t give a predication on where market levels will be 10 years from now. But considering what we’ve learned in the last 10 years, its safe to say focus on risk management will only increase, will be more integrated in investment processes and will continue to get more sophisticated.

What are your predictions?

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