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Risk Management - August 24, 2011

Risk management is as much about return enhancement as it is about risk reduction - an interview with Lionel Martellini

In this month's interview, we talk to Lionel Martellini, Professor of Finance at EDHEC Business School and Scientific Director of EDHEC-Risk Institute, about the importance of risk management for institutional investors, the role of the investment horizon in asset allocation decisions, and the connection between portfolio optimisation and risk management.

Lionel Martellini

In the wake of the financial crisis the question of risk management is prominent in the minds of institutional investors. What do you think have been some of the problems with risk management in the past?

Lionel Martellini: Well, one issue is that risk management is often mistaken for risk measurement. This is a problem since the ability to measure risk properly is at best a necessary but not sufficient condition to ensure proper risk management. Another misconception is that risk management is about risk reduction. In fact, it is at least as much about return enhancement as it is about risk reduction. Indeed, risk management is about maximising the probability of achieving investors’ long-term objectives while respecting the short-term constraints they face.

In the end, the traditional (asset management or asset-liability management) static strategies without a dynamic risk-controlled ingredient inevitably lead to under-spending investors' risk budgets in normal market conditions (with a high opportunity cost), and over-spending their risk budgets in extreme market conditions.

So what is the solution to these problems?

Lionel Martellini: The solution is to design new forms of risk-controlled investment that are customised to meet investors' expectations. These new forms rely on improved, more efficient performance-seeking portfolio and liability-hedging portfolio building blocks, as well as on improved dynamic allocation strategies. Although each of these ingredients can be found in current investment products, it is only by putting the pieces of the puzzle together and by combining all these sources of expertise that the asset management industry will address investors' needs satisfactorily.

From the technical perspective, these advanced investment solutions also rely on a sophisticated exploitation of the benefits of the three competing approaches to risk management: risk diversification (a key ingredient in the design of better benchmarks for performance-seeking portfolios), risk hedging (a key ingredient in the design of better benchmarks for hedging portfolios), and risk insurance (a key ingredient in the design of better dynamic asset allocation benchmarks for long-term investors facing short-term constraints), each of which represents a hitherto largely unexplored potential source of added value for the asset management industry.

I should mention that while diversification is most effective in extracting risk premia over reasonably long investment horizons and is a key component of sound risk management, it is ill-suited for loss control in severe market downturns. Hedging and insurance are better suited for loss control over short horizons. In particular, dynamic asset allocation techniques deal efficiently with general loss constraints because they preserve access to the upside. Diversification is still very useful in these strategies, as the performance of well-diversified building blocks helps finance the cost of insurance strategies.

How important is the investment horizon when making asset allocation decisions?

Lionel Martellini: The horizon is important in the sense that a long horizon is a more typical situation for most investors. While most investors still use static optimisation models, such one-period asset allocation models are only valid when investors have a short-term horizon. The development in academia of dynamic asset pricing theory has led to the emergence of improved investment solutions that take into account the changing nature of investment opportunities for long-horizon investors. These forms of investment are broadly referred to as life-cycle investing strategies, but current forms of life-cycle investing are sometimes grossly sub-optimal. For example, a popular asset allocation strategy for managing equity risk on behalf of a private investor in the context of a defined-contribution pension plan is known as deterministic life-cycle investing. In the early stages, when the retirement date is far away, the contributions are invested entirely in equities. Then, beginning on a predetermined date (ten years, say) before retirement, the assets are switched gradually to bonds at some pre-defined rate (10% a year, say). By the date of retirement, all the assets are held in bonds.

While such a basic form of deterministic life-cycle investing strategy is a simple strategy popular with investment managers and consultants, and it is widely used by defined-contribution pension providers, there is no evidence that it is an optimal strategy in a rational sense, and we argue that these strategies are very imperfect proxies for truly optimal stochastic life-cycle investing strategies. In general, the presence of risk factors can impact the opportunity set (risk and return parameters), and they can have a direct impact on the wealth process for non-self-financed portfolios when inflows and outflows of cash are taking place.

What is the connection between portfolio optimisation and risk management?

Lionel Martellini: Optimisation relates to diversification, the primary goal of which is neither to reduce risk nor to control drawdowns during severe market downturns, but instead to construct the portfolio with the best risk-adjusted performance across many different market conditions. In this sense, diversification is a major ingredient in constructing the performance-seeking portfolio (PSP).

Portfolio optimisation is a straightforward procedure, at least in principle, in that it consists of generating a maximum Sharpe ratio portfolio. In practice, investors end up holding more or less imperfect proxies for the truly optimal performance-seeking portfolio, if only because of the presence of parameter uncertainty, which makes it impossible to obtain a perfect estimate for the maximum Sharpe ratio portfolio.

The allocation to the PSP is a function of two objective parameters, the PSP volatility and the PSP Sharpe ratio, and one subjective parameter, the investor’s risk aversion. The optimal allocation to the PSP is inversely proportional to the investor’s risk-aversion. If risk aversion rises to infinity, the investor holds only the risk-free asset, as should be expected. For finite risk aversion, the allocation to the PSP is inversely proportional to the PSP volatility, and it is proportional to the PSP Sharpe ratio. As a result, if the Sharpe ratio of the PSP is increased, one can invest more in risky assets. Hence, risk management is not only about risk reduction; it is also about performance enhancement through a better expenditure of investors’ risk budgets.

About Lionel Martellini

Lionel Martellini, PhD, is a Professor of Finance at EDHEC Business School, Scientific Director of EDHEC-Risk Institute and Scientific Advisor to EDHEC-Risk Indices & Benchmarks. He holds graduate degrees in Economics, Statistics and Mathematics, as well as a PhD in Finance from the University of California at Berkeley. Lionel is a member of the editorial board of the Journal of Portfolio Management and the Journal of Alternative Investments. An expert in quantitative asset management and derivatives valuation, Lionel has published widely in academic and practitioner journals, and has co-authored reference textbooks on Alternative Investment Strategies and Fixed-Income Securities.