The Choice of Asset Allocation and Risk Management

Asset management is justified as an industry by the capacity of adding value through the design of investment solutions that match investors’ needs. For more than fifty years, the industry has in fact focused mostly on security selection as a single source of added value. This focus has somewhat distracted the industry from another key source of added value, namely, portfolio construction and asset allocation decisions. In the face of recent crises, and given the intrinsic difficulty of delivering added value through security selection decisions alone, the relevance of the old paradigm has been questioned with heightened intensity, and a new paradigm is starting to emerge.

In a nutshell, the new paradigm recognises that the art and science of portfolio management consists of constructing dedicated portfolio solutions, as opposed to one-size-fits-all investment products, so as to reach the return objectives defined by the investor, while respecting the investor’s constraints expressed in terms of (absolute or relative) risk budgets. In this broader context, asset allocation and portfolio construction decisions appear as the main source of added value by the investment industry, with security selection being a third-order problem.

Academic research has provided very useful guidance to the ways asset allocation and portfolio construction decisions should be analysed so as to best improve investors’ welfare. In brief, the “fund separation theorems” that lie at the core of modern portfolio theory advocate separate management of performance and risk-control objectives. In the context of asset allocation decisions with consumption/liability objectives, it can be shown that the suitable expression of the fund separation theorem provides rational support for liability-driven investment (LDI) techniques that have recently been promoted by a number of investment banks and asset management firms. These solutions involve, on the one hand, the design of a customised liability-hedging portfolio (LHP), the sole purpose of which is to hedge away as effectively as possible the impact of unexpected changes in risk factors affecting liability values (most notably interest rate and inflation risks), and, on the other hand, the design of a performance-seeking portfolio (PSP), whose raison d’être is to provide investors with an optimal risk/return trade-off.

One of the implications of this LDI paradigm is that one should distinguish two different levels of asset allocation decisions: allocation decisions involved in the design of the performance-seeking or the liability-hedging portfolio (design of better building blocks, or BBBs), and asset allocation decisions involved in the optimal split between the PSP and the LHP (design of advanced asset allocation decisions, or AAAs). Each level of analysis involves its own challenges and difficulties, and while the LDI paradigm is now widely adopted in the institutional world, very few market participants adopt an implementation approach of the paradigm that is fully consistent with the state-of-the-art in academic research.

Asset allocation and portfolio construction decisions are intimately related to risk management. In the end, the quintessence of investment management is essentially about finding optimal ways to spend risk budgets that investors are reluctantly willing to set, with a focus on allowing the greatest possible access to performance potential while respecting such risk budgets. 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 shortterm constraints) are shown to be three useful approaches to optimal spending of investors’ risk budgets, each of which represents a hitherto largely unexplored potential source of added value for the asset management industry.

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 shortterm 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 underspending investors’ risk budgets in normal market conditions (with a high opportunity cost), and over-spending their risk budgets in extreme market conditions. This idea was intuitively discussed in Bernstein (1996): “The word risk derives from the Latin risicare, which means to dare. In this sense, risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about.”

The Six Research Programmes

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 Institute's advisory board, which brings together distinguished scholars, representatives of regulatory bodies, as well as senior executives from business partners and other leading institutions.

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:

• 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, the “Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation” strategic research project, in partnership with CME Group, and the “Structured Equity Investment Strategies for Long-Term Asia Investors” strategic research project, in partnership with Société Générale Corporate & Investment Banking.

• 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 innovative approaches to constructing new forms of indices in the traditional and alternative universes. As such, 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. In 2010, EDHEC-Risk Institute, on the basis of its research results in the area of index and benchmark construction, set up a spin-off, EDHEC-Risk Indices & Benchmarks, the goal of which is to make available to investment industry professionals new forms of indices and benchmarks that genuinely add value in terms of both being efficient and representative of risks. 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.

• 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 “Dynamic Allocation Models and New Forms of Target-Date Funds” research chair, in partnership with La Française AM, the “Asset-Liability Management Techniques for Sovereign Wealth Fund Management” research chair, in partnership with Deutsche Bank, the “The Case for Inflation-Linked Corporate Bonds: Issuers’ and Investors’ Perspectives” research chair, in partnership with Rothschild & Cie, the “Advanced Investment Solutions for Liability Hedging for Inflation Risk” research chair, in partnership with Ontario Teachers’ Pension Plan, and the “Solvency II Benchmarks” research chair, in partnership with Russell Investments.

• 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 assetliability 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 also led EDHEC-Risk Institute to promote a new approach to measuring current volatility on the equity markets which no longer relies on the options market.

  This programme includes the “Structured Products and Derivatives Instruments” research chair, sponsored by the French Banking Federation, and “The Benefits of Volatility Derivatives in Equity Portfolio Management” strategic research project, in partnership with Eurex.

• 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.