Volume 8, No. 1, First Quarter 2010

Practitioner’s Digest • Vol. 8, No. 1

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.

Lessons on Investment Management From the Global Recession and Bear Market

by: Frank J. Jones

The current global recession and financial crisis have significantly affected virtually all investment managers. The severity of the effects on investment management risk has induced many investment managers to reconsider their investment approaches in terms of investment management risk. This paper summarizes and evaluates many of the resulting lessons learned by the author from these effects of the crisis. The perspective is that of a high net worth investor. Some of the lessons learned by investors, however, are inappropriate responses to the investment crisis and are refuted. These are, however, other responses investors should learn and consider using prospectively. These responses include both modified responses to the financial crisis we have witnessed and also new quantitative methodologies which have been developed to treat the investment problems which have been encountered. Among the issues considered are: (1) the utility of MPT; (2) the development process of contagion and a quantitative response to contagion; (3) quantitative and qualitative rebalancing; (4) recent evidence on the ERP (Equity Risk Premium) and the stock/bond allocation; (5) the paradigm of extreme events (a.k.a. the black swan) and hedging extreme events; (6) the changing role of liquidity in investment management; (7) a consideration of risk tolerance in portfolio development and others. Overall, the paper reviews both potential strategic and tactical responses with respect to these issues to the recent severe financial crisis from the perspective of a high net worth investment advisor.

The Long View of Financial Risk

by: Lisa R. Goldberg and Michael Y. Hayes

We discuss a practical and effective extension of portfolio risk management and construction best practices to account for extreme events. The central element of the extension is (expected) shortfall, which is the expected loss given that a value-at-risk limit is breached. Shortfall is the most basic measure of extreme risk, and unlike volatility and value at risk, it probes the tails of portfolio return and profit/loss distributions. Consequently, shortfall is (in principle) a guide to allocating reserve capital. Since it is a convex measure, shortfall can (again, in principle) be used as an optimization constraint either alone or in combination with volatility. In principle becomes in practice only if shortfall can be forecast accurately. A recent body of research uses factor models to generate robust, empirically accurate shortfall forecasts that can be analyzed with standard risk management tools such as betas, risk budgets and factor correlations. An important insight is that a long history of returns to risk factors can inform short-horizon shortfall forecasts in a meaningful way.

Do Endowment Funds Select the Optimal Mix of Active and Passive Risks?

by: Keith C. Brown and Cristian Tiu

The investment decision confronting managers of multi-asset class portfolios can be characterized in terms of the passive (i.e., benchmark or policy) and active (i.e., market timing and security selection) strategies they adopt. In this paper, we investigate whether managers select the appropriate combination of active and passive allocations in their portfolios. Noting that this issue is ultimately a risk management question, we adapt a simple framework for establishing what constitutes the optimal level of active and passive risk exposures. We then examine the question empirically using a database consisting of the allocation decisions and investment performance of a large set of university endowment funds over the period from 1989 to 2005. Our findings show that (i) the average endowment had too little active risk exposure in its portfolio, (ii) endowment funds could have significantly increased their risk-adjusted performance by enhancing the scale of the alpha-generating strategies they were already employing, and (iii) this tendency to underutilize active management skills was more pronounced for larger endowments than for smaller ones. We conclude that the typical endowment fund could have improved its performance by increasing the commitment to its active management skills.

New Directions in Financial Sector and Sovereign Risk Management

by: Dale Gray and Andreas A. Jobst

The global financial crisis that began in 2007 has forced a re-examination of macroeconomics, financial economics, regulation, and risk management. Traditional macroeconomics overlooks the importance of risk which makes it ill-suited to analyze risk transmission, contagion and how risks can build up and suddenly erupt in a full blown crisis. Risk management concentrates on analysis of risk at the level of the individual institution. What has been missing is comprehensive analysis of systemic financial risk and its links to sovereign risk. This essay illustrates how risk management tools and contingent claims analysis (CCA) can be applied in new ways to the financial system, to economic sectors and the national economy. CCA is a valuable tool to improve systemic financial sector and sovereign risk management. A new framework is developed to help the measurement, analysis and management of systemic risk with immediate practical application to the analysis of government risk exposures, their associated contingent liablitities, and potential destabilizing feedback processes between the financial sector and the sovereign balance sheet. In this regard, a new framework called Systemic CCA is described and an illustration of its application is given. This paper concludes with proposals on several new directions in managing financial sector and sovereign risk.

Non-Normality Facts and Fallacies

by: David N. Esch

Recently there has been an increasing trend in the quantitative finance community to call for statistical models which are explicitly model returns with non-normal probability distributions (e.g. Sheikh and Qiao, 2009, Bhansali, 2008, Harvey and Siddique, 2004). In this paper, we explain why summary rejection of normal distributions is almost always ill-advised. First, we examine some of the motivations for using normal models in financial applications. These models can account for non-normal return distributions despite their normal model components. We then demonstrate some consequences of switching to more complicated and less well-known non-normal models. These models almost always have more parameters to fit from the same data. All else being equal, rational investors should prefer parsimonious models, especially when the historical signal is weak, as is often the case in finance. We survey the shortcomings of several popular non-normal financial modeling techniques, especially when implemented naively. Although certain problems may warrant the use of other statistical return distributions, we argue that it is still important to exhaust the possibilities of normal models before switching to them. Models with normal distributions can be extended through methods such as conditioning on other variables, inequality constraints, mixtures, integration and resampling over unknown parameter distributions, or in some cases non-linear transformations. The mathematical properties of the normal distribution facilitate these model-building techniques and allow for thorough post-analysis and model-validation to ensure the best choice for the final model. Because of the preceding arguments, we reject the popular fallacy that normal models cannot be valid or useful because return distributions have marginal non-normal distributions.

Global Investing

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

Guide to Investment Strategy: How To Understand Markets, Risk and Behaviour

by: Peter Stanyer • reviewed by: Elroy Dimson

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

Some Lessons Learned in 42 Years of Business

by: Charles E. Harris

From 1984 to 2008, I had the pleasure and privilege of serving as Chairman and CEO of Harris & Harris Group, LLC, a publicly traded venture capital firm based in New York. Upon my retirement, I decided to summarize lessons I learned in my 42 years in business for the benefit of the incoming CEO. My colleagues have urged me to publish this summary, which consists of the following five broad categories of observations: advice for entrepreneurs and venture capitalists, leadership and general management, people issues, corporate governance, and investing. I am most grateful to the Journal of Investment Management for allowing me to share my thoughts in this Insights column.