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How to Deal With Excessive Risk Concentration?
Jonathan Jacob of Forethought Risk, an independent risk advisory firm, sent me his Benefits Canada article, How to deal with excessive risk concentration:
In my previous column, Examining portfolio risk,
we discussed ex-ante risk, ex-post risk and how both measures can
provide greater understanding of portfolio risk. In this column I would
like to discuss the options that are available to a pension fund
manager that discovers excessive risk concentration in a fund through
ex-ante risk reports.
When a pension fund
utilizes the services of multiple investment managers, there is
potential for overlap of risk, causing excessive concentration of risk.
Excessive risk concentration can be found in exposure to a single
company, a sector of the economy, or a currency among others. If the
pension fund manager receives ex-ante reports on risk which aggregate
all investment manager portfolios, he or she may recognize an exposure
as excessive prior to a potential blow-up.
One potential approach
to the excessive risk is to ask one of the investment managers to trim
risk to the asset with excess exposure. The investment manager will
likely disapprove the request, justifiably claiming that the initial
agreement did not include such restrictions and any future measurement
of their performance will be tainted by this decision.
An
excellent method of circumventing this issue would be the establishment
of a “shadow portfolio,” a paper portfolio which would include the
original positions desired by the fund manager. This shadow portfolio
would not be subject to the restrictions caused by aggregate excessive
risk concentration, while the actual portfolio would include those
limitations. Over time, the shadow portfolio would once again converge
to the actual portfolio either due to the investment manager removing
the forbidden positions from the shadow portfolio or due to the pension
fund manager lifting the restrictions since other investment managers
have voluntarily lightened risk allocations to the asset in question.
A second approach to excessive risk concentration is the use of an overlay portfolio.
The
overlay portfolio is a portfolio managed by the pension fund manager
to mitigate aggregate risk of the fund itself. The advantages of this
approach are its lack of interference with the individual investment
managers and the flexibility it provides to the pension fund manager.
Unfortunately, it requires greater oversight to ensure proper risk
management principles are being adhered to and a lengthy approval
process to create such a vehicle.
The final approach is simply an informative one.
The
pension fund manager provides the board and trustees with the
knowledge that risk concentration is high in a particular asset. The
pension fund manager will engage in intense monitoring of the asset in
question and only request liquidation of risk at predetermined loss
thresholds. This approach allows investment managers freedom to pursue
their investment strategies with interference only occurring when
necessary. The disadvantage of this approach is the potential for the
asset to gap lower, thereby creating losses far in excess of the
original threshold. Furthermore, trigger points are occasionally ignored
and must be enforced by an investment committee or board.
There are three potential approaches to managing aggregate risk concentration created by multiple asset managers:
- immediate reduction of risk,
- use of an overlay portfolio, and
- the establishment of trigger points for risk reduction.
The
optimal approach may vary, depending on the organizational structure
of the pension fund. No matter how a pension fund manages the issue of
risk concentration, ex-ante risk reports provide valuable information
to the pension fund manager with respect to aggregate fund risk
exposure and risk concentration.
I thank
Jonathan for sending me this excellent comment and I want to expand on
it a little. Jonathan correctly states if the pension fund manager
receives ex-ante reports on risk which aggregate all investment
manager portfolios, he or she may recognize an exposure as excessive
prior to a potential blow-up.
Here is the problem: those ex-ante
reports have to aggregate risk from all investment portfolios,
which include both public and private markets. This sounds easy and
straightforward but it isn't. In private markets (real estate, private
equity, and infrastructure), you run into stale pricing due to
infrequent valuations And in some absolute return strategies, risk
aggregation can be very deceptive, especially if it's an illiquid
strategy when a crisis hits.
Take a Canadian pension fund that
is invested in the commodity and energy heavy TSX, then does private
equity ventures in oil and gas, invests in commodity trading advisors
(CTAs), in hedge and long-only funds, in commodity futures index,emerging markets and is
long the Canadian dollar. Risk aggregation could be a nightmare if it's
not done properly across all portfolios, leaving a fund vulnerable to
serious downside risk.
And as far as overlay strategies, you need a CIO responsible for all
investment portfolios, internal, external across public and private
markets to make the calls and reduce overall risk at a fund. To do this
properly, the CIO needs to have excellent risk aggregation reports but
that's not enough. This person needs to have a central research team
that focuses on leveraging off all sources of information, including the
pension fund's external and internal investment managers (knowledge
leverage), to produce high quality quantitative and qualitative research
for all investment portfolios. This research group acts like the
central nervous system of the pension fund and needs to be staffed by
senior investment analysts from all groups. Importantly, they need to
work well together and work well under pressure, always focusing on
total fund risk.
Long gone are the days where risk is only quant
oriented. More and more large pension funds in Canada are leveraging off
their external partners to add in-depth qualitative research based on
rigorous economic and financial analysis. In this environment, you got
to think like a Bridgewater. And the bigger you are, the more important
this becomes because you have to react quickly, be nimble and be able to
take advantage as opportunities present themselves (go back to read my
comment on OTPP's Neil Petroff on active management).
Finally,
concerning my personal portfolio, I can tell you excessive risk
concentration can be very painful when you're concentrated in a certain
stock or sector and it's going against you. I've had a wild ride making
and losing money with a Chinese solar stock called LDK Solar. Just
check out the price action over the last year, and pay attention to the
last three months and days (ticker is LDK; click on image to enlarge):
LDK and Trina Solar (TSL) both got whacked on Tuesday, down on heavy volume after Trina guided lower on margins (click on image to enlarge):
OUCH! Talk about a sunburn! Should have listened to Jean Turmel's wise advice!
Now, to be truthful, I've traded this stock enough and seen many crazy
periods before. I tripled down on LDK when it double bottomed at $5 last
year, and I'm getting ready to add to my position (already started and
got burned today so now I am waiting).
Chinese solar stocks are not for the feint of heart.
When they move, they move abruptly in both directions. You got to buy
them when they're way oversold (or wait for them to base after huge down
moves on big volume) and sell them when they explode up. A lot of big
hedge funds are accumulating and manipulating these stocks, as I will
show this weekend when discussing 13-F filings for elite funds in Q1
2011 (I will cover all sectors, not just solars).
Excessive risk
concentration matters. It matters for your personal portfolio and it
really matters when you're managing other people's money, which is what
pension funds are doing. And to properly understand excessive risk
concentration, these pension funds need strong quantitative and
qualitative analysis across all investment portfolios in public and
private markets. While this sounds straightforward and easy, most
pension funds lack the tools, systems, external partner relationships
and most importantly, investment professionals on the inside who are
thinking properly about risk aggregation across all investment
portfolios. It's total fund risk that ultimately matters, which is why a
lot of large institutional managers got killed in 2008.
***Feedback***
One senior pension fund manager sent me this comment, which sums it up well:
Seeking
to manage this risk on some sort of systematic data capture basis
seeks false precision, and turns investment management into a giant IT
project. What is needed is simply one person, even in a large
organization, to stay on top of broad goings on, and on occasion
commission staff to do special ad hoc analysis. We used to call this
person of experience a chief investment officer...
And Jonathan Jacob added this comment:
Your commenter has a point –
it can be difficult to obtain quality data from custodians and that
data must be run through a quality assurance process. My article was
not so much directed at those large pension funds with significant
systems and employee resources but more toward those funds that are
severely understaffed (2-3 employees) and who outsource the investment
management function to external managers.
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1: http://www.youtube.com/watch?v=qVE60zwXx1k
2: http://www.youtube.com/watch?v=B7NTYeRg5Dg
3: http://www.youtube.com/watch?v=0ZXP03W8-AM
Leo,
You are such a trusting accolyte of the church of the markets.
Don't you know the majority are heretics and alms filchers?
Bless you, I know you have a good heart.
Why have multiple asset managers? Doesn't each one involve a fee?
This is like two Parents saying that the more children they have the less they will have to worry. Yeah, right, sure.
Honestly, couldn't you just have an investment mix that varied according to the ratio of central bank lending rates versus a basket of commodities? That would give you a pretty good balance no matter the index fund/investment and would reduce your fees.
Too many cooks spoil the soup.
Besides, the Wall Street/Hedge fund gang know you Pension folks are plodding Wooly Mammoths, and they have a time machine and large caliber scoped rifles.
I would advise you to not be overlapping anything or anyone as that simply ads to your cost, risk, and exposure to the ponzi.
Engage stealth mode.
Risk management, on a (personal) portfolio level, is the misunderstood but crucial essential. I'll bet not one in one hundred individual traders manage risk properly. But software like Trading Blox (not a plug, but check it out) is accessible and offers portfolio-level risk management for individuals.
I have been intimately involved with stocks for the last 15 years. The last 25 months or so have been very profitable, so I don't understand the comments about rigged markets, or the inability to make money. Individual stocks still go up and down. Simple technical chart patterns actually seem to work better than they did a few years ago. And the action is consistent with the emotions of traders as well as the action of large players on longer time frames. The prices have been choppy lately. I see signs of some distribution and change of trend, particularly in the natural resource stocks.
The ETF's are tricky for me. I have to be shorter term than usual to catch a profit, but that is usually due to my overweighting of correlated macro ideas, and my psychologic inability to stand drawdowns. But, if i'm patient i can still make money.
This bull market is a little long in the tooth tho, and it is probably not the time to be putting on long term long positions.....
good article leo!
gh
I went to the race track with Grandma's money.
I bet my usual spread and drank, ate, smoked, and laughed with the other gamblers.
I took 5% off the top of Grandma's take; she wins, she loses, I always make money.
What is wrong with that crazy old broad for being upset with me for not making her any money for the past 10 years? I made money, the other boys made money, the track made money, what gives?
She must not be taking her medication...
LOL!
Don't understand about rigged markets. Do you think Bernie Madoff is honest? Do you think Goldman Sachs and J.P. Morgan are honest? If you do, I can't defend your illusion. I think anybody who sells me something and says it is good, then shorts it knowing it was bad is crooked and a thief. Enough said on that point. As far as trading the markets, I'v been at is since the 70's. Not a beginner. QE2 has been good. That's why the market keeps going up. Don't fight the FED lives on. But right now, with No Volume to speak of, the market is manipulated in any way the hedge funds want. Fundamentals of any kind do not matter. They see every dime that is real money enter. If Goldman, the Morque and BAC are winning every day, someone is losing big. The climate has changed.
Just a note: Robert Pretcher of EWI has for the past three years told clients to put a short on. Lately, for the third time. Every time has failed. He is a stupid ass because he says the FED does not matter. That's his failure. But, if the FED takes away the punch bowl, it is over. Period. The real economy sucks. My instincts have taught me that every time gas prices cause pull backs in consumers, (ie Walmart, Lowes and Sears), a correction is not far behind. A correction in the economy and the markets.
The market has now left reason. Valuations and growth are not fundamentals one can play. Good Commodity stocks trading at PE's less than 15 going down. Three Hedge Funds have perfect 90 days of trading. My bad, one missed by one day. Those hedge funds, Goldman Sachs, J.P. Morgan Chase and Bank of America are like Bernie Madoff. Something is very wrong. The SEC is not doing their job. You only accomplish a quarter like that if the market is rigged or you are the manipulator.
Hello, The Market is Rigged. For myself. I'm Out. I Don't Want to Play in a Rigged Market. One that hedge funds who have banking status manipulate. That special sauce software Goldman owns, the software that they said one can rig the markets with IS what they are doing. Taking your money, suck you in, and the squid attacks.
Stay out till they bust it up or someone does the right thing and puts them in Jail. Buy physical PM's on dips. That's my take. Besides, we are heading for a double dip great recession anyway.
News Flash: Egypt ask the United States, (IMF), for $4,000,000,000.00 to plug a hole in their budget. 4 Billion, Who's next?
I agree.
There is no winning outside of pure luck in what are now completely absurd, illogical, and severely warped markets (distorted by massive interventionist monetary policy of equally absurd design and proportions).
So, it's a casino in markets. Logic and the greatest analysis won't help, and may hurt, at a time when some of the very worst quality (non-quality?) equities have seen the greatest outperformance (I could list some of these fly by nights, but everyone here is aware of some of these frauds that have literally risen 300% to 1200% in the last two years).
I can't find the article, but the world's most successful financial advisor for a period of 30+ years, who had accrued average returns of nearly 10% annually, net of all fees and commissions, has opted to sit out of the markets entirely since 1997.
When asked why he did so well and why he chose to opt out, he replied that he did well consistently because he stayed massively underinvested near the boom and bust cycles, and that he opted out entirely of the markets since 1997 because the markets were essentially rigged casinos more manipulated than at any time since the late 1920s, and maybe more so.
If someone could find the article and link it, I'd be much obliged.
So if he's out of the market, where's his money? Bank? Treasuries? I am over 50% cash, but I am trading here and there.
If you stay 50% cash and get caught flat-footed on the other 50% and you get whammied by a 50% market drop, you still have 75%. Then, at that point you go all in and when things recover, you're at 150%.
But if you sit on the sidelines 100% cash at all times, you might never get the big drop you seek and then what? Inflation eats away at your capital.
Better to nibble arround the edges with short term trades and bank some coin while you wait for the big one.
Did Peter Fonda keep surfing small waves in ?Escape from LA? while he was waiting for the big Tsunami? You bet he did and you'd better too.
Wow.
A decently written article (regardless as to whether I agree with the conclusions therein - but I do, with much of them) that has empirical data to support its propositions, and the cherry on top of some analytical reasoning, to boot.
I knew that you had it in you, Leo.
If I contrast this article with the rubbish you cobbled together in the past couple of weeks, there is no way I would ever have guessed or believed it was produced by the same writer. It's incredible, actually.
The biggest problem I have with your thesis outlined in this article is that you are presupposing that managing aggregate risk can be done more appropriately via a pigeonhole approach, versus a simple broad basket, indexing approach, whereby no one asset or even asset class constitutes more than a single digit percentage of one's overall investments, and whereby the indexing encompasses a very large swathe of assets and asset classes, and appropriate hedging of risk is engaged in in order to mitigate extreme volatility.
Bogle would rightfully pick apart some of your assertions because you and those you quote assume that you can more often than not mitigate against the unknown and unknowable qualities and actions of the market, over a long time horizon (where even the big hand of central banks and governments can't mitigate the black swan events - often, ones that they helped set the table for via prior actions).
I thus rated this article 3 or 4 stars (it is well written, but I disagreed with a few premises and conclusions).
TIS,
All large pension funds are already doing ''enhanced indexing'' internally. I agree with you but indexing is also fraught with risks, especially if one stock makes up a big percentage of the index (Canadians remember Nortel).
Nice response, TIS.
I will also grudgingly admit that this article is a giant step up for "him" from the shallow and ludicrous Keynesian claptrap of recent weeks.