The Choice of Asset Allocation and Risk Management

Investment management, as an industry, is justified by its ability to add value by designing solutions that meet investor needs. For more than fifty years, the industry has focused on security selection as its greatest single source of added value. This narrow focus has kept key sources of added value—asset allocation and risk management—largely out of view. In the wake of recent crises, and given the intrinsic difficulty of delivering value through security selection, the relevance of the old paradigm has been seriously called into question. The separation of alpha and beta that has been made explicit by the core-satellite portfolio management approach has effectively put the emphasis back on risk and asset allocation decisions.

One of the most significant developments in asset pricing theory is its recent emphasis on the close ties binding dynamic portfolio selection and contingent claim pricing. Such path-breaking advances in academic research have blurred the frontiers between investment management and investment banking and led to a new generation of financial engineering techniques that aim to design optimal investment offerings that truly take into account the investor’s specific constraints and objectives. These new offerings draw simultaneously on the benefits of the three competing approaches to risk management—risk diversification, risk hedging, and risk insurance—each of which has hitherto remained largely untapped as a source of added value for the investment management industry. Blending active management with risk control, new dynamic asset allocation techniques offer manifold welfare-enhancing applications in asset-only and asset-liability management.

It is against this backdrop that EDHEC-Risk has decided to structure all of its work around asset allocation and risk management and thereby to put the collective expertise of its permanent staff and research associates at the service of key needs of financial institutions and investors. This strategic choice is applied to all of EDHEC-Risk’s research programmes, whether they involve putting forward new asset-allocation techniques that span traditional and alternative investments, measuring the performance of funds while controlling for their underlying dynamic factor exposures, identifying biases in existing indices and designing superior instruments for benchmarked asset allocation, taking extreme risks into account in the allocation process, using derivatives to implement active portfolio strategies and replicate indices, or improving asset-liability management techniques.

It is also in these particularly exciting times of far-reaching change in the financial industry that EDHEC-Risk Institute has launched a PhD in Finance programme to equip exceptional individuals with the conceptual and technical tools needed to meet the challenges for which the investment banking and investment management industries must be prepared, and an Executive MSc in Risk and Investment Management for professionals in the investment management industry who wish to progress or maintain leadership in their field.

An Applied Research Approach

In a desire to ensure that the research it carries out is truly applicable in practice, EDHEC-Risk Institute has implemented a dual validation system for the work of the research facility. All research work must be part of a research programme, the relevance and goals of which have been validated from both an academic and a business viewpoint by the centre’s advisory board, which is made up of both internationally recognised researchers and the centre’s business partners.

To date, the centre has implemented six research programmes that explore interrelated aspects of asset allocation and risk management to advance the frontiers of knowledge and foster industry innovation.

The Six Research Programmes

• Asset Allocation and Alternative Diversification

  The research carried out focuses on the benefits, risks, and integration methods of the alternative classes in asset allocation and makes significant contributions to the field of multi-style/multi-class portfolio construction. In particular, EDHEC-Risk research has advanced non-parametric risk estimation methods and extended the Bayesian approach to portfolio construction in the presence of preferences about higher moments of return distributions.

  The programme includes the “Advanced Modelling for Alternative Investments” research chair, in partnership with Newedge Prime Brokerage.

• Performance and Style Analysis

  This programme aims to adapt the portfolio performance and style analysis models and methods to tactical allocation and to new forms of investments. Research looks at performance evaluation in traditional classes–investigating socially responsible investing or analysing rating methods for long-only funds–and at performance evaluation in the hedge fund universe (implementing dynamic factor models). The programme has led to a business partnership with SIX Telekurs and to the offering of the EuroPerformance-EDHEC style ratings, a service measuring the quality of active management in the European fund management industry.

• Indices and Benchmarking

  This programme involves two aspects of research into indices and benchmarks in traditional and alternative investment. The first aspect looks at the quality of indices, the criteria institutions use to select them, and revisits modern portfolio theory to develop new approaches to building efficient indices. In response to criticism of the lack of representativeness of hedge fund indices, EDHEC-Risk has proposed a proprietary method of style index construction for the alternative universe and launched the first composite hedge fund strategy indices in 2003. The second aspect of this research programme examines the use of index products in the core-satellite approach to investment management.

  This programme includes the “Core-Satellite and ETF Investment” research chair, in partnership with Amundi ETF, the EDHEC-Risk IEIF Commercial Property Indices and the FTSE EDHEC-Risk Efficient Index^TM series.

• ALM and Asset Management

  This programme concentrates on the application of recent research in asset-liability management (ALM) for institutional, high net worth, and retail investors. The research centre is working on the idea that improving asset-management and strategic allocation techniques has a positive impact on the performance of ALM programmes. It devotes particular attention to the institutional context of ALM and to the impact of International Financial Reporting Standards and the Solvency II directive project on European pension funds and insurance companies. It also aims to extend the realm of ALM approaches to address the particular needs, constraints and objectives of sovereign wealth funds, the private banking clientele, and mass-affluent investors.

  This programme includes the “Regulation and Institutional Investment” research chair, in partnership with AXA Investment Managers, the “Asset Liability Management and Institutional Investment Management” research chair, in partnership with BNP Paribas Investment Partners, the “Private ALM” research chair, in partnership with ORTEC Finance, the “Dynamic Allocation Models and New Forms of Target-Date Funds” research chair, in partnership with UFG, and the “Asset- Liability Management Techniques for Sovereign Wealth Fund Management” research chair, in partnership with Deutsche Bank and “The Case for Inflation-Linked Bonds: Issuers’ and Investors’ Perspectives” research chair, in partnership with Rothschild & Cie.

• Asset Allocation and Derivative Instruments

  This research programme focuses on the use of derivative instruments for portfolio management and on dynamic asset allocation methods in asset management and asset-liability management. Key themes include the optimal design of structured products, the role of structured products and derivatives in asset allocation, “passive” replication of “active” hedge fund indices through portfolios of derivatives, and structured products and derivatives on underlying instruments that are illiquid or lack liquidity.

  This programme includes the “Structured Products and Derivatives Instruments” research chair, sponsored by the French Banking Federation.

• Operational Risks and Performance

  The financial crisis has been synonymous with a transfer of a portion of investor risk towards the providers of investment and related services. The difficulties that third-party fund management has experienced in the areas of asset security, pricing and compliance with regulation, suggest that this shift in the responsibilities of those involved in fund management will have a significant impact on the profit and loss accounts not only of the fund management firms but also of all the service providers who are associated with them. Against this backdrop, this research programme aims to identify the operational risks parties to the fund management industry bear as a result of their practices and of regulations, assess the importance of these risks and their impact on the parties’ solvency and business models, and propose means of mitigating these risks.

  The programme includes the “Risk and Regulation in the European Fund Management Industry” research chair, in partnership with CACEIS.