Wednesday, February 17, 2010
Don't miss FactSet's upcoming Risk events
March 10 Seminar
Risk: The challenges of multiple asset classes
Join FactSet and the CFA Toronto for a luncheon on March 10, where Senior Product Manager Bill McCoy will address the multiple challenges of building a risk model that truly meets the needs of multiple asset classes.
March 11 Seminar
Fixed Income Management Essentials: From single bonds to risk analysis
We'll be in Boston on March 11 from 9:00 a.m. to 1:30 p.m. to present a comprehensive and educational event on the challenges of managing a fixed income workflow.
March 11 Luncheon
Risk for Super Funds
In Melbourne, we'll discuss why Super Funds should not only be thinking about risk, but analyzing it in a sophisticated way. FactSet and our risk partners APT, Barra, and Northfield will describe how Super Funds can measure, manage, and understand the risks they are taking or external managers are taking on their behalf.
March 17 Live webcast
Accurately Measuring Risk Across Asset Classes
Most risk models are either equity focused with some fixed income flavor or fixed income models with some rudimentary equity addition. An accurate total risk model must unite, in one framework, descriptors of various equity, currency, and fixed income risks to provide a very granular view of both equity and fixed income markets. Only this type of model can truly report risk across asset classes.
Daniel Satchkov will demonstrate how to accurately measure risk across all asset classes through a collection of risk statistics such as Value at Risk (VaR), Expected Tail Loss, Kurtosis, Skewness, Tracking Error, Stress Testing, and others.
For the latest in FactSet events, follow us on Twitter @FactSet.
Wednesday, February 10, 2010
A quick VIX?
On this stage, we have discussed the suitability of a risk model in terms of matching its forward looking horizon to a client’s investment process. I’m the first to agree that this indeed is an important dimension and should be considered carefully. What use has a risk prediction if the information is too late to react to? That said, I have noticed a trend among the different risk model providers to provide shorter term horizons in addition to their standard models. Both Barra and Axioma provide shorter and longer term versions of their risk models, and Northfield has produced near term versions of most of its models. The major focus of such models is to pick up increased levels of risks faster. Now, one could philosophise whether these additional horizons have arrived in time and whether they could have provided adequate warning signals for the multi sigma events we encountered in late 2008, but the fact remains that these models are here now and can provide useful insight if deployed in the right manner.
To highlight this responsiveness, consider the observed jump in the VIX over the last couple of weeks (while not all encompassing, the VIX is considered a valid proxy as a broad indication of perceived risk in the markets). As a broad indicator, the recent movement gives as an opportunity to see if and when a short-term model picks up on such an event. To do so, I decided to look at the absolute risk levels of some broad indices, in this case the FTSE All World, S&P 500, and MSCI Europe. I did this using the R-Squared Global Risk model, a daily updated model designed to predict risk on the ultra short horizon and to be very responsive.
Considering the above charts, we clearly see increases in the levels of risk after spikes in the VIX, especially during the last week. The magnitude of the impact in the spike seems related to the amount of exposure to the U.S. Market in our three indices (VIX is a measure of the volatility of the U.S. S&P 500 Index options).
Now consider the monitored impact on a monthly model. It’s going to be both less timely and a more drastic. This because the factor variances will be updated from month end to month end, so a fund may perceive a shock in predicted risk from one day to the other (when the model updates), while the fund composition itself didn’t change.
We’re not suggesting a quick fix here, saying one should only look at short term risk. But we do advocate multiple horizon measurement; longer term risk management may reflect the strategy of a fund, but when markets volatility rises, the information and analysis permitted through a shorter term model carries real value.
Subscribe by e-mail to receive new Taking Risk posts as they are published.
Monday, February 8, 2010
Notes from the IPARM conference in Hong Kong, part 3
The second day of the Third Annual Investment Performance Analysis and Risk Management Asia 2010 (IPARM) conference at the Kowloon Shangri-La in Hong Kong, China began with a panel discussion on the lessons learned from the global financial crisis and the roadmap for 2010 and beyond. Jean-Marc Sabatier, Head of Risk Management Asia for Amundi, started off the conversation talking about how 2010 is the year of opportunity for risk management, particularly in Asia. He cited two reasons:
- Human resources. Management finally sees the need, nay, the requirement, for a real risk management team in place and are finally willing to pay and support to keep a highly respected team in place.
- The balance of power has switched (a little bit). In the past, if the risk manager said “no,” it was acknowledged, but then everyone moved on. Now, risk managers are more easily and readily able to say “no” to portfolio and managers and marketing groups and actually carry some weight.
Jean-Marc also added that the job of a risk manager is no longer only about reporting; the job of a risk manager begins with the risk report. Oliver Bolitho, Managing Director from Goldman Sachs Asset Management, then discussed the concept of regret risk which in Asia is related “to a ‘face’ thing that leads to taking logic off the table." Oliver believes this is one of the bigger issues facing the industry as he has see countless examples of portfolio managers turning off their thinking when faced with an investment decision.
From the audience, the panel was asked who should have the final say on the risk of a portfolio? The portfolio manager? Risk manager? Combination of the two? Someone else?
Oliver jumped in first by describing risk as a culture. He continued by saying that if we tried to codify risk, it will get boxed in and will not be there when we need it most. By way of example, if we codified risk (e.g, you could only buy securities with a certain rating), just think what people would have bought in the past few years. Oliver concluded that he thought the risk manager should have the final say, but it should not be up to a single person.
Also in response to the question, Dr. Lincoln Rathnam, CFA, Global Head of Investment Management for EM Capital Management, mentioned the positive experience he had working for an investment management firm that was a partnership and anyone at the firm could say no. Anecdotally, Lincoln thought that having a corporate structure of a partnership was a prime reason why Brown Brothers Harriman escaped relatively unscathed from the financial crisis; everyone at the firm had a veto and they avoided the toxic assets that others so readily accumulated. But ultimately, Lincoln’s answer was that he thinks there needs to be a balance of power between the portfolio manager and the risk manager, one party always wants to say yes, the other party wants to say no, and a middle ground that must be found.
There was also a brief discussion about the “age factor” of risk managers (also known as the “value of experience” to the older demographic). In Asia, and perhaps globally, many risk management teams are junior, i.e., it is often a junior member of the investment management team and all too often someone who has not gone through many of the historical ups and downs. There were no firm answers on how to address this issue, although Jean-Marc mentioned that Amundi recently announced a new policy in which all Portfolio Managers must spend at least three years serving in a risk management capacity. Lincoln made the analogy to General Electric back in the Jack Welch days when he mandated as part of their executive management program that everyone had to spend some time in internal audit.
Next up was Dr. Stan Uryasev, Editor-in-Chief of the The Journal of Risk, who gave a talk on deviation CVaR (Conditional Value at Risk). While this risk measure has been around for a while, as a co-inventor of the methodology, Stan was able to expand on the methodology both in theory and practice. Of particular note, Stan emphasized that CVaR is most useful for risk management, not risk measurement. I strongly encourage those of you interested in learning more to check out his slides that he has made available on his website here.
After serving on the panel, Lincoln pulled double duty with a presentation on stress testing, although to me, the most interesting part of his talk was when he touched on the topic of crisis. Contrary to most, Lincoln believes that “crises are not rare events. We go from crisis to crisis to crisis. It is our nature.” Not a comment you can ignore coming from a man with over 30 years of investment management experience, and to solidify his point, he made reference to a list of financial panics, scandals, and failures. Far from comprehensive, I am sure, but it did cement his point that the next crisis is never too far away as it goes through crises starting in the 17th century and ominously ends with nothing next to number 210.
The final panel of the day focused on finding a risk model or performance system that is appropriate for your investment process. Dr. Laurence Wormold, Head of Research at SunGard APT, started things off with his three pillars of risk analysis:
- Risk measures: The simple stuff, tracking error, VaR, etc.
- Attribution: In Laurence’s words, “turning 1 number into 100.”
- Stress testing and scenario analysis: In his mind, this is the most often ignored aspect of risk analysis as he firmly believes in building shocked market risk models.
A member of the audience immediately jumped in questioning Laurence’s assertion as every firm that he knew of did some form of stress testing. Lawrence acknowledged this, but added that for most firms, stress testing is a box ticking exercise that is largely ignored throughout the company. The stress testing that most firms do lack imagination and is too simplified (e.g., S&P 500 goes down 20%). For the most part, the stress testing that is in the marketplace today suffers from a herd approach; everyone is testing the exact same thing. Laurence further suggested that the current tests should be anchored in economic plausibility; a firm should start from a historical event and then invite colleagues to take that information and think about other ways to create realistic scenarios.
Overall, IPARM Asia was a well organized conference with a very solid slate of speakers and I was quite happy to hear that the organizers have already announced that the fourth annual conference will take place in Hong Kong again next February.
Subscribe by e-mail to receive new Taking Risk posts as they are published.Thursday, February 4, 2010
The illusion of stability, part 2: What fuels bubbles?
"It wasn't me. It was the one-armed man. Alright, alright, I confess. I did it, you hear? And I'm glad, glad, I tell you! What are they going to do to me, Sarge? What are they going to do?"As if to respond to my 2009 year in review post, Ben Bernanke came up with a huge speech (please do not smile; I wrote “as if”) outlining why zero real interest rates have had no effect on the housing prices. With this groundbreaking discovery, he opened 2010 by declaring war on common sense and possibly laying claim to the Noble Prize. Yes, you heard it right, zero interest rates do not affect housing prices.
"Sorry, son, that's not my department."
- Jim Carrey in the The Mask
Let's consider some of the Chairman’s arguments:
The Taylor Rule
Bernanke invoked a formula called the Taylor rule which purports to proscribe appropriate monetary policy to strike a balance between economic growth and inflation of asset bubbles. Bernanke suggested that if forecasted inflation rate is used as an input into the Taylor rule then Fed’s policy of zero real interest rates in the years when the housing prices were exhibiting explosive growth then the rule suggests that the policy was appropriate. Taylor himself responded to Bernanke explaining that he misinterpreted and misused the rule. Without getting into any mathematical detail, the first question to ask is, "How valuable can a rule be, if different inputs can be used to provide any result you want?" Imagine a space engineer whose creation crashed and injured the public proclaiming that he used a different gravity constant and therefore was correct. The point is that economics is not physics and a heavy dose of common sense is needed. Even Taylor himself said that mathematical discussions should not obscure the plain fact that interest rates were ZERO.
Smoke and Mirrors
"The fact that our econometric models at the Fed, the best in the world, have been wrong for 14 straight quarters does not mean they will not be right in the 15th quarter." - Alan Greenspan in a testimony before Congress
In the second argument, Chairman Bernanke made a similar attempt to cloud economic discussion with equations carrying a boatload of assumptions which will give most any answer desired. He referred to a set of econometric models developed at the Fed based on the technique called Vector Autoregression. Using past values of housing prices, interest rates and other economic variables, the model can be coaxed into showing what values are reasonable for any one of the variables given the actual values that were observed for the rest (conditional distribution). Using that technique, it can be shown that only about half of the explosive housing growth can be attributed to the Fed’s policy. In addition to eschewing common sense, there are fairly obvious and fatal statistical problems with Bernanke analysis:
- The model was calibrated during the period of non-zero interest rates and then linearly extrapolated into the zero interest rate period. It assumes that the relationships between variables are linear and constant, that there is nothing inherently different about zero interest rate environment and that only changes in variables matter. Needless to say, all these assumptions are flawed, and this is a perfect example of the fallacy of linearity of which I have written here.
- The range of housing prices conditional on the interest rates was limited to two standard deviations. Even using Bernanke’s own heroic assumptions there is still 32% of the distribution remained outside. When looking at the graphs at the end of the speech, it become fairly obvious why two standard deviations were used. Simply put, three standard deviations would not give the desired answer; the line would be too close to the actual housing line, thus suggesting that even with all its flaws the model rather contradicted the speaker.
Adjustable Rate Mortgages and Rates
The third argument was that the problem stamped from lax regulations not from zero interest rates. Here is one quote from the speech:
“Moreover, less accommodative monetary policy would not have had a substantial effect on ARM payments…Clearly, for lenders and borrowers focused on minimizing the initial payment, the choice of mortgage type was far more important than the level of short-term interest rates.”
Here, the Chairman is partially right, and his call to create a systemic risk agency can only be applauded. However, to argue that low interest rates had nothing to do with the proliferation of creative mortgage lending is to ignore the reason why people took on ARM mortgages in the first place. They did so because housing prices were rising at a tremendous pace for a number of years before. As Bernanke himself shows, ARM mortgages did not become popular until 2006, which was closer to the end of the bubble. Without zero interest rates, we would not be talking about them.
More Smoke and Mirrors
“'You might just as well say that "I see what I eat" is the same thing as "I eat what I see"!'
'You might just as well say,' added the March Hare, 'that "I like what I get" is the same thing as "I get what I like"!'
'You might just as well say,' added the Dormouse, who seemed to be talking in his sleep, 'that "I breathe when I sleep" is the same thing as "I sleep when I breathe"!'
'It is the same thing with you,' said the Hatter …” - Lewis Carroll, Alice in Wonderland
Bernanke's last point confuses the whole matter even more:
“In particular, we need to understand better why some countries drew stronger capital inflows than others. I will only note here that, as more accommodative onetary policies generally reduce capital inflows, this relationship appears to be inconsistent with the existence of a strong link between monetary policy and house rice appreciation.”
Essentially, what this passage is saying is the following: Countries with real estate bubbles exhibited higher capital inflows. Since higher capital inflows usually happens when interest rates are high and not when they are low all this is very confusing. The interest rates must not have been low after all.
This kind of reasoning implicitly assumes that economics can be described by the same functional relationships as Newtonian physics, i.e., that if high interest rates cause capital inflows then high capital inflows will not occur when interest rates are set too low. It assumes a kind two-way relationship that is called one-to-one correspondence in mathematics.
Why did the Chairman have to avoid considering the possibility that capital inflows can be caused by reasons other than high interest rates? Is it not the obvious conclusion that the capital inflows were caused by the very presence of the various bubbles that Alan Greenspan and Ben Bernanke then denied? Who cares about a few percentages in interest rates when values of assets are doubling?
What does all this mean for a risk manager? It means that Ben Bernanke sees no inherent problem in zero interest rates as long as Consumer Price Inflation stays low. This in turn means that we are in for another decade of Black Swans. Buckle up.
Subscribe by e-mail to receive new Taking Risk posts as they are published.
Monday, February 1, 2010
Notes from the IPARM conference in Hong Kong, part 2
A day full of fascinating discussions at the Third Annual Investment Performance Analysis and Risk Management Asia 2010 (IPARM) conference at the Kowloon Shangri-La in Hong Kong, China. Hope you've been enjoying my live tweets from the conference.
Kicking the event off was Trevor Persaud, the Head of Investment Risk Oversight and Performance at Prudential Asset Management in Singapore. Trevor's topic was redefining the roles and responsibilities of performance analysts and risk managers to better support the investment management teams. Trevor started off his presentation by asking the audience whether the portfolio manager at their respective firms was the only person at the firm who can say exactly what is going on in a particular portfolio. While Trevor acknowledged that this was expected since the PM should have the expertise, he questioned whether this lack of challenge and oversight is healthy for the fund. From his experience, he has found that independent expertise of a fund helps moderate the action a PM might otherwise undertake.
Having worked in both Europe and Asia, the first question asked of Trevor by the audience was what were the big differences between the risk management function in the two regions? Trevor cautioned his response by saying this was not a sweeping statement, but he thought that in Asia, up until recently, the role was purely operational, very limited independence and oversight. However, of late, he has noticed that in Asia, there is a thicker layer of senior management (compared to Europe where the Portfolio Manager is king), and management has been more receptive to risk managers looking to take a more active role and becoming more than just serving a pure operational function. In Europe, Trevor thought that risk managers have taken on more responsibility than their Asian counterparts, but that a risk manager's ascension is capped, there comes a point (and I hope he was speaking from personal experience) when the risk manager is at peril of overstepping his or her bounds in the hierarchy of a European investment management firm.
Daniel Wallick, Principal in the Investment Strategy Group at Vanguard, gave an equally interesting talk and got everyone's attention when he equated risk management with the Allegory of the Cave from Plato's The Republic.
For those who haven't read the book since high school, Daniel's analogy was that risk is similar to man looking at the shadows on the wall in the cave; we are not really sure what we are looking at. Daniel's talk expanded into the two reasons why we need risk management (people are imperfect and crises happen) and ended with four interesting fundamentals that are followed at Vanguard:
- Risk management is an integral part of the investment decision making process.
- An enduring value-added investment program in good ties and (crucially) in bad.
- Top-down qualitative judgment/rigor + discipline in quantitative measures.
- No substitute for the judgment and experience of the risk management and investment teams.
Daniel's session ended with a question from the audience on his assessment of the current risk environment in the U.S. given his experience and focus there. Daniel replied that he was not specifically concerned near term with inflation (in the U.S.), but what concerned him was how exactly should the Fed back out of what it has been doing and how/when do they do that.
There were a couple of additional speakers today who covered topics that I will take up in a future blog post. As for tomorrow, we have an equally interesting set of speakers and topics coming up in day two of the conference, some that have caught my attention include:
- Dr. Stan Uryasev, Editor-in-Chief of The Journal of Risk, who will be seeking alternatives for VAR as risk measure.
- A panel discussion on finding the right risk model and measurement system that is appropriate for your investment decision process, particularly interesting since my colleague covered this topic in a blog post last month.
- Peter Urbani, CIO at Infiniti Capital who will be revisiting risk management and performance measurement for hedge funds.
Please check back early next week for a recap on these interesting topics.
Don't miss the next post in this series. Receive new blogs by e-mail.
Notes from the IPARM conference in Hong Kong, part 1
In particular, I am looking forward to hearing from:
- Trevor Persaud, the Head of Investment Risk Oversight and Performance at Prudential Asset Management in Singapore (and Chair of the conference) who will discuss redefining the traditional role of risk managers.
- Dr. Lincoln Rathnam, CFA, Gloal Head of Investment Management at EM Capital Management who will be giving a talk on stress testing.
- Jean-Marc Sabatier, Head of Risk Management Asia for Credit Agricole Asset Management who will be speaking on data management best practices.
- Daniel Wallick, Principal in the Investment Strategy Group at Vanguard who will be examining some of the key challenges of risk adjusted performance measurement in the current market.
Watch this blog later in the coming week as I post on some of the interesting topics covered at the IPARM two day conference.