Greater sophistication in risk management limits unwelcome surprises in outcomes
Why does this matter to the average investor? Because effective risk management by portfolio managers, aided by a specialised Analytics team, is both an offensive and a defensive weapon. It enhances portfolio outcomes and creates value for clients. Rigorous analysis supports better investment decisions and improves risk-adjusted returns.
We are all familiar with the concept that higher risk implies the possibility of higher returns (and lower risk implies lower returns). But it is not that simple – managing that risk successfully requires sophisticated techniques. Key elements of an effective risk management framework are governance; identification and measurement; infrastructure; monitoring, migration and management; and communication. We’ll discuss each of these elements in turn.
The agreement, or mandate, between the portfolio manager and the client is essential to the management of a portfolio. The mandate provides guidelines and sets limits for the portfolio manager to achieve the desired return based on the client’s permitted risk tolerance. The mandate also includes other elements, such as regulatory requirements to ensure compliance.
Given the relative importance that fixed income securities play in a well-diversified multi-strategy portfolio, the STANLIB Analytics team has placed considerable emphasis on overseeing fixed income, and we have developed our own fixed income portfolio management tools. Our fixed income attribution model examines alpha (value added or lost), helping the portfolio manager to understand how the intended strategy compared to the actual outcome.
Another proprietary in-house fixed income portfolio alignment tool is ACTUS. This tool helps the portfolio manager to ensure similarly-mandated portfolios deliver similar results.
Risk tolerance determines the amount of risk the portfolio manager is willing to take to achieve the desired outcome. Risk budgeting determines where, based on the manager’s conviction levels, most of the allowable risk should be taken.
Identification and Measurement
Absolute risk refers to the portfolio’s risk taken in isolation, while relative risk is a comparative measure, such as the portfolio’s risk compared to the benchmark’s.
When risk is viewed in isolation, generally the portfolio’s volatility (or standard deviation) is used to assess the riskiness of the portfolio, independent of a benchmark. This is commonly referred to as the “absolute risk” of the portfolio. Typically, when portfolios are viewed in isolation, portfolio managers must decide whether either to hold cash (and be comfortable to earn a cash-equivalent return) or take views on specific securities that they believe will outperform holding cash. Within the portfolio, each security’s weight represents its contribution to the portfolio’s overall volatility.
Relative risk is more informative for portfolios that track a benchmark which portfolio managers are aiming to outperform. Relative risk (or tracking error) expresses the portfolio’s exposure to systematic risks and the level of idiosyncratic (or security-specific) risk. Idiosyncratic risk can be diversified away, to ensure the only risk in that portfolio would be market risk. But market risk is not without cost, either. As portfolio managers introduce more market risk into the portfolio by chasing higher yields, the opportunity cost increases, which leads to a more uncertain outcome. We employ various tools to measure these risks in the hope of creating a more certain outcome for our clients.
Risk infrastructure refers to the resources and systems required to track and assess portfolio risk profiles. STANLIB invests heavily in software applications, skilled and seasoned analysts, technology and data to ensure that informed decisions can be made speedily and accurately.
Visualisation enables pattern recognition and trend analysis. It allows portfolio managers to decipher and communicate, and it facilitates complex decision-making. We use fully interactive dashboards that are available in the cloud, so we can access this information from mobile devices and personal laptops, any time and anywhere.
Monitoring, Mitigation and Management
Continuous risk monitoring is what we do every day. The portfolio managers must check and assess that all risks are in line with the limits of the defined, agreed upon, risk tolerances. If we see that those limits have been breached, we take risk mitigation and management actions to modify risk levels to more acceptable levels. Analytics team members have a deep understanding of the macro and micro economic backdrop and the portfolios, enabling them to question portfolio managers’ views.
Reports, which are generally the preferred method of communication, are part of STANLIB Analytics’ oversight function. Communication, which continues even when risk levels are within accepted risk tolerances, creates an active feedback loop, enhancing investment decision-making.
Strategic Analysis and Integration
The final step of a good risk management framework is integrating all the key elements. Integration is a fine balancing act. It has to allow portfolio managers enough room to manoeuvre without inhibiting them from expressing their views. Ultimately, a good risk management framework requires collaboration, teamwork and a sound relationship between the Analytics team and portfolio managers, through bull and bear markets.