A Paradigm Shift In Risk Management

People often value their risk systems on how well they can rate the past. One of the worst things you can do as a risk manager is look backwards says Olivier Le Marois, Chairman at Riskdata
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People often value their risk systems on how well they can rate the past. One of the worst things you can do as a risk manager is look backwards, says Olivier Le Marois, Chairman at Riskdata, a risk management provider for pension funds and institutional investors.

Riskdata relies on purely quantitative analysis to avoid any bias stemming from any ex-post knowledge of funds’ performance.

From this approach, Riskdata has recently released a study that reveals how investors can hedge their portfolio against catastrophic “perfect storm” financial market events at no cost through quantitative risk management techniques.

Entitled “Keeping the Devil in its Box”, the paper looks at how – in the wake of a market meltdown institutions can manage portfolios and cap potential losses by integrating extreme risk budgeting into their investment process.

Much like financial celebrity Nassim Taleb whose funds offer a form of investment insurance in times of black-swan events Riskdata sets extreme risk budgets and uses robust quantitative models that aims to eliminate fat tail risk. This is because it actually allows investors to take more every day risks while using cheap and effective hedges to cover extreme risks, says Marois.

Although we may not agree on all of Talebs principles of risk management, he is driving a very similar message to us: Stop worrying about day to day volatility. You should be more concerned about tail events, Marois continues.

What we propose is that most pension fund managers and individual investors arent that interested in making vast amounts of money, they are more concerned about not losing vast amounts. We say once you have hedged your tail risk then you can think differently on your investment policy in the day-to-day market

Extreme risk budgeting is a technique of setting up and complying with a limit on the maximum loss of a portfolio. Such extreme risk budgeting not only caps losses in a “perfect storm” type of event, but crucially can often cost only a marginal amount in terms of “business as usual” performance. And, when extreme risks are under control, an investor can take more “business as usual” risk.

“We’re seeing more and more pension funds and other institutional investors shifting their focus from “business as usual” risk premium and volatility to extreme risk budgeting because this approach, post the market crash, appears to be the only way over the long term to exceed the risk-free rate while matching liabilities,” comments Marois. “This study demonstrates that setting extreme risk budgets and using robust quantitative models can create strong value at acceptable cost both in “business-as-usual” periods and in periods of instability. This is because it actually allows investors to take more every day risks while using cheap and effective hedges to cover extreme risks.”

Marois also believes we are seeing a paradigm shift in investing. Asset managers generally do what their clients tell them to do. If they stop having pressure from clients asking about Sharpe Ratios and low volatility, but rather have clients asking about how much they can potentially lose when things go very wrong, then the attitude of the market will shift.

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