March Risk Management has always played a crucial role in Portfolio Management, but recently more focus, energy, and attention is being placed on this capability. Risk Management across the Financial industry continues to evolve for several reasons. First, a technological evolution of Investment Management software, where analytic platforms continue to get faster, and more robust, is improving managers’ ability to see portfolio risk. Second, investors clamoring for more transparency following the Financial Crisis and subsequent Great Recession of 2008 dictate a focus on risk. Lastly, Active managers are seeking to convince passive investors that they should pay a fee for better, or less risky, returns as a matter of survival as outflows transfer into less expensive strategies such as Index Funds.
Further, the increased focus on Governance, Risk Management, and Compliance (GRC) programs and protocol, has also drawn Investment Management Risk into the industry dialog, spawning many conversations about the place of Investment Risk within a GRC framework. In order to understand how and why Risk is mitigated, we first must explore the basis of Financial Analysis.
How does Passive Management influence Risk Management, Active Strategies, and more importantly Technical Analysis? As previously mentioned, the rise of the Passive Management Index fund is exploding. According to Morningstar, flows to Passively managed funds outpaced Actively managed by a record of $500 billion in 2015, and in the last five years, passive investments have gone from a quarter of long-only assets to one-third. Active managers, seeking to stop the hemorrhaging, are looking for new ways to add value for the Investor, including less-risky returns at higher yields.
Strategies to achieve the above include Risk-parity, where positions are allocated in a portfolio based on risk as opposed to dollar weightings, and Overlay strategies using Derivatives. Options overlays can avoid downside risk while providing income, specifically in a Covered Call strategy. Implementing these strategies, however, becomes daunting without the power of a sophisticated Risk Analytic engine running in the background. Historically, these engines have been the exclusive domain of the Technician, with Fundamentalists eschewing them for more traditional methods.
These methods created the division between technical and fundamental analysts. Fundamental Analysts use financial statements, and economic and market metrics to construct their portfolio. Technical analysts assumed they had an advantage because they could use superior programming skills to analyze distributions, dispersions and deviations of returns. Furthermore, these Technicians analyze the volatility of prices and can create models for visualization.
One key differentiator between those able to conduct Fundamental Analysis and Technical Analysis lies in the experience of programming skills. Technical Analysts were well skilled in open-sourced programs such as ‘R’ or MATLAB to run regression analysis, or model return distributions. More importantly, they can determine the probability of the expected tail-loss of that return distribution, which in and of itself is a more prominent risk measure.
Now, modern risk systems are increasing their functionality and closing the gap on the types of analytics previously unavailable to fundamentalists. Further, Millennials are coming into the workforce with capabilities and expectations of interacting with technology that further narrows the gap. The new analyst has the financial acumen, and the statistical analysis skills that was until recently out of reach, blurring the line between the two types of analysts within organizations that no longer view the skillsets as distinct.
The value proposition of Active Management in the future will hinge on the shift to better Risk Management. The increased deployment of hedge-like strategies will drive alpha generation. It has also become increasingly significant that the convergence of Risk and Performance measurement is key for this alpha generation. It is imperative that these be done in conjunction with each other. Was your predicted risk last month equal to your realized risk right now? The ability to understand this mapping of Ex-post to Ex-ante is an imperative quality of Investment Management systems.
As new money continues to flow out of Active portfolios and in to Passive strategies, Active managers must adapt to survive. Fundamental analysts must use the software available to them to optimize returns, minimize risk, and convince investors to hold tight. Converging the fundamental and technical Analyst skillsets and technologies is a natural evolution required to reinstate the value proposition of Active Management.
