EDHEC-Risk Institute believes that client servicing and the provision of investor solutions should respect a number of guiding principles: financial engineering should address client needs rather than showcase technical sophistication; the role of financial models should be to ensure that clients' genuine risk preferences are respected; and investors' objectives and liabilities should command equal respect whatever the clientele - institutional, private, or retail.

Some have wondered for example whether the failure of standard portfolio diversification techniques in recent years could be explained by their inability to account for extreme market moves. It is clear that simple mean-variance portfolio selection techniques drawn from modern portfolio theory are ill-adapted when asset returns show severe departure from the normality assumptions of the theory. As a result, numerous asset managers, both in the traditional and alternative investment spaces, have suggested that volatility be replaced by other risk measures such as Value-at-Risk or Conditional Value-at-Risk, for example, which put greater emphasis on the presence of extreme downside risk in asset returns. A recurring criticism of volatility is that it measures both the upside and downside risk of investment performance, while investors are generally only interested in downside risk.

While such attempts at incorporating extreme risk measures into portfolio construction techniques, with the prospect of enhancing diversification benefits in difficult market conditions, seem entirely legitimate from a conceptual standpoint, they do however pose serious implementation challenges.

Our research¹ confirms that mean-variance analysis actually dominates portfolio selection with higher-order moments if one uses naïve sample estimates, even in situation where deviations from normality are severe. Hence, managers trying to incorporate extreme risk measures in diversification techniques are likely to fall short of their overly ambitious goal unless they make a specific attempt to address the increased complexity of portfolio selection techniques that rely on extreme risk measures. This result confirms that one should prefer mean-variance analysis if one is not prepared to use improved risk parameter estimation techniques, which are designed to help reduce the number of parameters to estimate by imposing some structure on the estimation problem.

In trying to minimise extreme risk and make their risk evaluation more sophisticated, many asset managers increase the number of risk parameters to be estimated, which in turn leads to less robust and less relevant results than if they had stuck with a simple measure of portfolio volatility. Good intentions are only rewarded if they are backed up by a serious effort at meeting the challenges related to the increased complexity implied by the more ambitious expectations.

Similarly, in our research on taking an asset-liability management approach to private wealth management², we have provided a framework suggesting that asset-liability management is an essential improvement in private wealth management that allows private bankers to provide their clients investment programmes and asset allocation advice that truly meet their needs.

Broadly speaking, our analysis has shown that taking an ALM approach to private wealth management generates two main benefits. First, it has a direct impact on the selection of asset classes. In particular, it leads to a focus on the liability-hedging properties of various asset classes, a focus that would, by definition, be absent from an asset-only perspective. Second, it leads to defining risk and return in relative rather than absolute terms, with the liability portfolio used as a benchmark or numeraire.

This is a critical improvement on asset-only asset allocation models, which fail to recognise that changes to asset values must be analysed in comparison to changes in liability values. In other words, private investors are not seeking terminal wealth per se so much as they are seeking terminal wealth whose purchasing power enables them to achieve such goals as preparing for retirement or buying property.

As part of our mission to ensure that best client practices are highlighted to the industry, EDHEC-Risk Institute has launched the Executive MSc in Risk and Investment Management programme to train professionals to embrace and lead the major changes that will reshape investment management. This postgraduate programme is designed to be completed in seventeen months of part-time study and is formatted to be compatible with professional schedules. The programme is offered in Asia—from Singapore—and in Europe—from London and Nice.

For more information on this programme, please contact Mélanie Ruiz:

EDHEC-Risk Institute Executive MSc Admissions – Ms Mélanie Ruiz 393-400 Promenade des Anglais BP 3116 - 06202 Nice Cedex 3 - France. Tel.: +33 493 187 819 - Fax: +33 493 184 554. Web: execmsc.edhec-risk.com Email: melanie.ruiz@edhec-risk.com

References

1. Improved Estimates of Higher-Order Comoments and Implications for Portfolio Selection, Lionel Martellini and Volker Ziemann, forthcoming in the Review of Financial Studies. This research was carried out as part of the "Advanced Modelling for Alternative Investments" research chair, sponsored by the Prime Brokerage Group at Newedge.

Asset-Liability Management in Private Wealth Management, Noël Amenc, Lionel Martellini, Vincent Milhau, Volker Ziemann. September 2009. EDHEC-Risk Institute Publication. This publication was produced as part of the EDHEC/ORTEC Finance research chair on Private ALM.