Written By: Toby Goodworth
Head of Risk

Many traditional methods of measuring risk can fall short when applied to alternative investments. Toby Goodworth of bfinance outlines an approach which could help investors when assessing their portfolio risk

Institutional investors’ focus on risk management has increased substantially since the beginning of the financial crisis, and continues to grow in importance more recently, having been spurred on by the European sovereign debt crisis. An institutional investor risk survey conducted by bfinance earlier this year1 indicated that over three-quarters of respondents now place greater emphasis on their portfolio risk management compared to two years ago. This is good news! However, the same survey also noted that these portfolios are becoming more complex, with increasing allocations to non-traditional, absolute return strategies.

Historically, it has been the norm for investors to access absolute return strategies through a fund-of-funds, thereby effectively delegating a substantial proportion of the risk management responsibility to seasoned experts within the field. However, post-crisis, there has been a concerted drive towards direct investments from both public and corporate pension plans, with industry participants currently noting these investors as representing a major source of new assets into the space.2 As these direct alternative allocations form an increasingly important component of pension plan portfolios, it becomes essential to have an appropriate portfolio level risk management framework with which to monitor and manage these investments. Unfortunately many traditional techniques often relied upon to assess portfolio composition and risk fall short when it comes to alternatives: capital weights do not reflect risk-weighted contributions to portfolio risk, historic returns do not accurately gauge current risk for more flexible investment mandates, and non-normal returns mean volatility is less informative as a risk measure – to name but a few. Many investors have also been required to make changes to way they conceptually view their portfolio, and therefore reassess their risk management frameworks. Rather than treating absolute return investments as a single line item to be reviewed on a standalone basis, it is arguably far more appropriate for pension plan officers to consider themselves as multi-manager portfolio managers, treating the portfolio in its entirety and assessing each constituent in the context of the rest of the portfolio. After all a given fund or investment strategy can seem perfectly suitable on a standalone basis, but fit rather awkwardly in the context of the overall portfolio by, for example, doubling up on existing risks, or not providing meaningful diversification.

By going direct, institutional investors give themselves a greater degree of control, allowing them to select only the most appropriate strategies for their portfolio. Empirically, we see this trend for direct investments being focused on strategically held diversifying alternative strategies such as relative value, systematic macro and more trading-oriented variable net exposure equity long/short strategies, rather than other more beta-rich alternative strategies. The rationale for allocating this way is two-fold; accessing return streams that are not accessible through lower cost traditional markets, and structurally improving the potential for better portfolio diversification. Accessing alternatives in a more tailored manner can be beneficial, but it also necessitates a more suitable risk management framework in order to accurately ensure that the aims are being achieved. Given the limitations regarding transparency within many alternative investments, the most appropriate and robust way to consider overall portfolio risk is top-down rather than bottom-up. Top-down approaches typically look to describe portfolio risk using an array of known risk factors in order to understand which combinations of risk factor exposures best explain the risk-return characteristics of the portfolio. These risk factors can then be stressed in order to understand how the portfolio might respond across a wide range of market environments, including extreme scenarios that might not have been experienced historically, i.e. it provides a method whereby one can assess the impact of what might happen as opposed to just what did happen.

Where alternative investments are concerned, this breaking of the dependence on what did happen i.e. the historic track record, and being able to consider what might happen is crucial for ensuring continued diversification and obtaining a more appropriate understanding of your real portfolio risk, given that many alternative investments have insidious risks that only rarely manifest themselves in realised returns. Because of this, such approaches can also provide more realistic estimates of the extreme downsides and therefore help reduce the likelihood of nasty surprises.

In addition to providing a more appropriate measure of overall portfolio risk, i.e. less dependence on historic returns, such risk management approaches are also capable of attributing the sources of risk within the portfolio by fund, asset classes, investment style or the individual risk factors themselves, and it is this capability that is vital in allowing the scheme’s officers an understanding of which funds are diversifying the portfolio and how. Indeed, when it comes to multi-asset portfolios, one of the benefits of a factor-based approach is that it speaks a universal language, meaning the same basic approach can be used whatever the asset class or investment style, be it alternative or traditional, thus allowing all portfolio constituents to be assessed under a single all-encompassing risk framework. By understanding the origins and styles of risk across the portfolio in this way, it becomes relatively straightforward to identify where multiple risks are converging, or conversely which elements are actually acting to diversify the overall portfolio. Furthermore, looking at your portfolio from a factor-based risk perspective can be very enlightening if your portfolio itself is comprised of multi-asset investments such as diversified growth, balanced, or multistrategy funds, as many of the sources of risk across these investments have the potential to be common in origin, and an apparently diversified portfolio by investment style or label can very quickly become a very concentrated portfolio by risk factor type.

By way of summary, it just remains to be said that it is impossible to encompass risk into a single measure, therefore the approach outlined here is often best used as a complement to existing position-level or administrator reporting rather than a replacement. To this extent we see significant interest from multi-asset institutional investors, both public and corporate alike, who wish to better understand their portfolio and its associated risks.


1. Risk Management MIG Special Report, bfinance (Apr 2013)
2. Credit Suisse Prime Services Report (Oct 2013)


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Published: November 1, 2013
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