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Thinking about Risk

Presented on April 18, 2006


What is Risk?
Markowitzs key insight: risk can be proxied by volatility. But in general, risk is not simply the volatility of cash return
Example: comparing 1 month bills to 10 year zeros What is risky depends on your economic circumstances, in particular on your liabilities Two steps for dealing with this issue: (1) find the minimum variance portfolio, which depends on your liabilities; then (2) calculate portfolio risk as the volatility around this minimum variance portfolio

Min. Variance Portfolio for Individual Investors

The minimum risk portfolio is heavy in TIPS, which match the implicit liability of your future consumption stream Volatility of return, calculated around this TIPS-heavy portfolio, is risk There are different minimum risk portfolios for different individuals, so you and I may differ about which of two portfolios is the riskier The relative income hypothesis and Keeping up with the Joneses risk

Min. Variance Portfolio for Defined Benefit Pension Plans

For a Pension Fund the usual objective is to maximize return/risk -- Information Ratio -- relative to plan liabilities
Usually, liabilities are nominal cash payments

Risk is the volatility of the plans surplus.

The minimum risk portfolio defeases your liabilities. Or, more accurately, it comes as close to defeasing it as it can. In practice it is unlikely a truly zero risk portfolio can be found. Nominal bonds work, and TIPS work if you have COLA

Min. Variance Portfolio for Fund Managers

Positions are managed relative to a benchmark

Risk is fluctuations in return compared to the benchmarks return

To avoid risk completely, hold the benchmark portfolio, assuming it is investable You still have business risk if you retreat to the benchmark too often

Min. Variance Portfolio for Hedge Funds

Absolute return orientation seems to imply cash is the benchmark But, these days hedge funds are normally measured against a peer group, an appropriate index of similar types of hedge funds The index is impossible to track. This means cash, with all its problems, is probably best

What are your Objectives?

More return and less risk When you formally optimize a utility function, as in MPT, you get two additive terms that describe the composition of the portfolio. They correspond to minimize risk then add some more return, in exchange for bearing more risk. We call them the passive (or hedging) portfolio and the active portfolio. There is corresponding passive risk and active risk. The active portfolio consists of two sub-portfolios, the beta portfolio and the alpha portfolio

Objective: More Return

There are two risky ways to get more return: (1) Add Systematic Risk. Buy asset classes that offer higher returns risk premiums compared to the minimum risk portfolio. Call this the Beta Portfolio. (2) Add Outperformance. Find managers who can beat quasi-efficient markets. Call their active positions their active bets away from the minimum risk portfolio, in aggregate, the Alpha Portfolio.



The Active Portfolio, Part 1: The Beta Portfolio

Should be a portfolio of many different risk premiums. There is no justification in theory for focusing almost exclusively on the equity risk premium. Is there any justification in having beta risk at all? The Miller-Modigliani theorem says probably not. MM prediction: the stock market does not increase your share price when you take beta risks in your pension plan. Taxes may modify this conclusion


The Active Portfolio, Part 2: The Alpha Portfolio

Is the collection of all the active bets taken by all your active managers, in aggregate. To reduce risk, it should be a portfolio of many different, independent alpha streams. This is sometimes called the Fundamental Law of Active Management.

Dont forget that alpha production is a zero sum game in the best case
Beware of beta being repackaged and offered by your manager as pseudo alpha.. If so, you need to adjust his results to find what his real alpha is, and how much alpha risk and beta risk you actually bear


The Hedging Portfolio: Importance of the Risk-Free Asset

With a risk free asset, the variance of the hedging portfolio and all its co-variances are equal to zero This makes attributing the sources of risk easy: all the risk comes from the active portfolio With no risk free asset, you bear passive risk as well as the more familiar active risk

Co-variances among active and passive risks may matter Partitioning risk by source is non-trivial

Where is you Risk Coming From?

We may want to partition the risk in the portfolio into 3 sources: the passive or Hedging portfolio; the Beta portfolio; and the Alpha portfolio. Recall the last two, taken together, constitute the active portfolio To do so, proceed as follows: First, take the partial derivative of volatility with respect to the hedging portfolio, H, then multiply the result by H. Second, repeat step 1 for B and A.

The sum of the three components is the total risk; the three components tell you which sources the risk is coming from
Notice that if H is risk-free, then the risk in the portfolio is all attributed to the active portfolio, as we would expect


Are you measuring risk appropriately? Your liabilities matter and they define your risk free asset Start with this risk free asset, or at least the minimum variance portfolio, as the core of your portfolio To earn extra return, you may wish to add a beta portfolio to reap the harvest of risk premiums the market offers. But in theory, this will not help your stock price. [MM] (So, why are we doing this ?)

If you think you can identify managers who can beat the market, then you can earn extra return by constructing a risky alpha portfolio. But in theory, this may not help your stock price. [MM again]
Pension plans would do best to focus on defeasing liabilities