Given that the process of assessing portfolio risks and making subsequent adjustments is not a strategy but a tactic, Sussman writes, âThis process should be undertaken as often as conditions on the ground warrant. In other words, even portfolio managers with longer time horizons should be doing more risk analysis, not less, in todayâs volatile trading environment.â However, he is quick to add that there will never be a perfect equity risk model. âTrade-offs must always be made between the sample size of a model and its sensitivity, the explanatory power of a model and our ability to explain the model.
Amid the current wreckage are the quantitative strategies that survived the August 2007 scare. Sussman points out, âthey have risen from the ashes more quickly than other equity strategies in part because they had already deleveraged and thus protected their funds against volatility â actions that proved almost prescient as the credit crisis kicked into full gear.â
Although few people would lay the quantitative quandary on the doorstep of equity risk models, much should be done to improve the solutions. These tools, he explains, should enable investment professional to:
â¢ View timely and relevant portfolio risk analytics (daily updates)
â¢ Align the parameters of the equity risk model to the investment strategy (time-weighting/transparency)
â¢ Understand sources of risk within the portfolio
â¢ Study the performance of the portfolio under different scenarios
â¢ Analyze (and potentially construct) portfolios using a mix of outcomes rather than the most probable outcome.
Fund managers, says Sussman, accept that third-party providers can only discover the systematic risk. It is the cutting-edge fund managers who examine the underlying algorithms of the factors within the third-party models, comparing them to comparable factors within their own models. âOnce they know the differences between the factors, they can be resolved or accounted for in the decomposition of the residual risk.â
Based on in-depth conversations with risk managers and portfolio managers at leading quantitative asset management firms and hedge funds, in addition to equity risk model providers, this TABB research note examines how sophisticated risk managers are finding new ways to react to sudden moves in the equity markets, and the characteristics of a risk model necessary to perform that analysis. It discusses the possible causes of the quantitative meltdown of late July and early August 2007, how quantitative managers adjusted their approach in light of that event and what risk managers today can take away from that event.
The note also covers the evolution of equity risk analytics, including daily versus monthly updates, responsiveness to near-term events, handling outliers, fundamental versus statistical approaches and transparency. It also focuses, says Sussman, on one of the more vexing problems facing quantitative managers, that âthere is no smooth handoff between the analysis of the third-party models and a firmâs proprietary model.