My predictions for the risk landscape of 2010

With the New Year I have no doubt you are also all looking to welcome in some changes, perhaps in the form of resolutions such as stopping smoking, losing a bit of weight, drinking less, spending more time with the family, more exercise, etc. Now we all know that past performance is no indicator of future performance, but on a personal level (and with the weight and exercise resolutions firmly in mind) I can easily see myself slipping back to the old ways all too soon and, therefore, am not going to go down the line of making these sort of pledges.

I decided instead that I might look forward to the year ahead and throw a few thoughts out there about how we may see the risk landscape change. There has been no new regulation as of yet from the SEC, FSA, or others, but I believe it is safe to say that the nature of any coming will not be of the "report less often and in less detail" variety.

Rationale: We have moved far from the old mantra "all risk is bad," but will regulation come in demanding justification any and all risks taken?

There is a level of risk inherent in any financial area, whether it comes from being exposed to a "split-strike conversion" strategy or just investing in a high yielding Icelandic bank account, so it is not the fact that there is risk per se that needs to justified, but that the risks being taken are reflected in the expected returns balanced with a complete picture of what the risks are. I hope that any new regulation in this area is focused on the explanatory angle rather than the justification one.

Responsibility: Will regulators look to firms to appoint individuals to take signatory control over portfolio risk levels in some kind of extension of the compliance departments, or will there be further encouragement towards a group responsibility?

Personally, I believe that we will see a move by firms themselves towards increased education, looking to ensure that everyone who has any interaction with a fund is aware of the risk characteristics of that fund. E.g., analysts providing recommendations for conservative, blue chip strategies should not be encouraging short term, alternative, emerging market exposures; portfolio construction tolerances should be set considering historic and comparative peer limitations; factsheets will report deeper variance contribution than just the top 10 holdings, etc.

Reporting: Will there be a push towards a "new" measure now that the "flaws of VaR" have been exposed?

Portfolio risk cannot be distilled down to a single number. Indeed some people would describe risk as more of a landscape than a point, but will providing a whole multitude of numbers really increase people’s understanding of risks and in what magnitude they exist? I have seen in a few clients already an acceptance that it will be necessary to embrace multiple methodologies that include different horizons (historical periods as well as both short term and long term ex-ante forecasts), different assumptions (normal vs. fat-tail, Stress Testing, Monte Carlo vs parametric, etc.) as well as different risk measures (Tracking Error, VaR, CVar, Expected Tail Loss). Making all of this available in an accessible, timely, and potentially interactive manner is a challenge that they are already looking to surmount.

These are just three areas that I wanted to comment on, and must (for legal reasons no doubt), stress that all comments made here are the views of me alone and do not in any way reflect those of FactSet Research Systems or FactSet Europe Ltd. But I encourage you all to reply directly or through the comments section below laying out your own thoughts to what possible changes to the risk landscape 2010 might bring.

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