Woodbine Associates, Inc.
  Capital Markets Consulting and Research

 

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Woodbine Opinion
September 16, 2013

Risk Management Used Purely as a Control Function Leaves Money on the Table

Many financial institutions consider risk management a control function focused narrowly on reporting and regulatory compliance.  This perception is unfortunate. The analytical framework firms develop, at significant expense, to satisfy regulatory risk requirements also generate a wealth of information that can improve the investment process.  Much of this information is simply ignored, leaving potentially large investment returns “on the table.”  A few straightforward modifications can help utilize this information and provide additional fruit to trading professionals.

Focus on Value at Risk (VaR)

VaR is a statistical measure of the amount of capital that could be lost with a given probability over a certain period.  It is typically defined as the potential capital loss that could occur with 5% probability within a year. This potential loss is often referred to as “95th percentile VaR.”

VaR, Overlooked Information and Investment Process Integration

Risk management groups that calculate VaR for regulatory and/or control purposes also produce a host of timely information that could benefit groups charged with investment return generation.  But in firms that treat risk management as a control function this information is walled off from the investment process.  The result is missed opportunities – day after day after day.

To estimate potential size of the 5% probability of loss for regulatory and control purposes, the risk management group calculating the 95th percentile VaR must generate prospective return/loss figures for every point along the return distribution.  

As shown below in Figure 1, estimating that a portfolio has a 5% chance of losing 19% over the course of a year requires calculation of the estimate of the corresponding 5% gain.  This potential gain is often overlooked because risk management is focused only on controlling downside risk. 


 
 

Return distributions need not be symmetric and due to sound portfolio construction frequently display positive asymmetry In our example below, The return distribution displays positive asymmetry in that there is a 5% chance of a 22% return, compared to a 5% chance of a 19% capital loss.

The 95th VaR loss of 19% enters the regulatory capital adequacy framework.  However, the equally likely 22% return frequently does not enter into the investment process. This shortcoming can be overcome through nominal investments in improved organization and communication between the risk management and investment units.  Of course, management must take care not to compromise or weaken the independence of the risk management group.

VaR and Alternative Investments

Incorporating VaR process information can be valuable in analyzing alternative investments.

Consider an asset manager deciding between an investment in a passive index or an actively managed portfolio. Both portfolios have the same risk-return exposures below the 5th percentile (95th percentile VaR gain) and above the 95th percentile loss (95th percentile VaR loss).  However, the actively managed portfolio provides greater returns at all points between the 5th percentile and the 95th percentile.  

Both portfolios have the same VaR and will therefore have the same regulatory capital requirements.  However, the return profile of the active manager is more attractive than the passive index, especially in the most likely range of +/- 1 standard deviation. Accordingly, the decision to invest in the active manager is justified by its ability to more effectively internally generate capital. 





On a tactical basis, the asset manager can compare the active manager’s actual performance to the passive index’s return distribution to insure that the active manager continues to deliver the performance for which it is being compensated.  In the example below, the active manager consistently delivers returns in the +1 standard deviation range and has avoided any significant drawdown.  The level of consistency in the active manager’s performance results in superior annualized cumulative returns, validating the results the active manager promised.



Conclusion

The 2008 Financial Crisis and the “London Whale” incident indicate that regulatory financial institutions are not getting what they paid for from their risk management functions.  This failure is largely a reflection of the perception that risk management is a control function more focused minimizing regulatory capital than providing investment value.  This perspective is unfortunate and need not be the case.  The analytical framework and infrastructure necessary to satisfy regulatory requirements also can be used to improve the investment decisions at no additional cost.  

Active managers, such as hedge funds, are increasingly being required by institutional investors like asset managers/pension plan to report VaR and other risk management statistics in order to obtain institutional funding.  The cost of build out an internal risk management function or using an external risk management advisory can be a significant expenditure.  Active managers are well advised to not consider these expenditures as simply a cost of doing business, but are better served by integrating risk management into their investment process.  

Jerry Waldron, Ph.D.
Director of Risk and Portfolio Analytics
Phone:  203-274-8970 ext 205
Email: jwaldron@woodbineassociates.com 

For a printable copy of this opinion in pdf format please click here.

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