The 3rd Younger Members Convention

1
The 3rd Younger Members Convention

• 29-30 November 2004, The Chesford Grange Hotel,
  Kenilworth

2
Innovation in Risk Management

• Risk is the essence of active investment
  management
• Effective risk management is essential to
  successful investment management
• Effective risk management is
• Credible
• Accountable
• Adaptable
• The objective is to add genuine insight into
  portfolio risk

3
Why innovate?

• More sophisticate investors
• Defined Contribution schemes and personal
  pensions
• Increasing awareness of the potential value of
  risk management as opposed to the potential
  cost of not having it
• More sophisticated investment products
• More sophisticated risk technology
• Demand is for effective risk management, not just
  box-ticking

4
What distinguishes effective risk management?

• Improves performance
• Accurate risk forecast allows the right amount of
  risk
• Enough to achieve investment objectives
• Avoid disasters
• Intuitive risk profile facilitates targeting of
  risk
• Risk taken only where it is expected to
  contribute to active returns
• Eliminate unwanted risk
• Risk analysis comparison encourages disciplined
  investment process
• Comparison between similar portfolio encourages
  consistent application of house views
• Comparison with analyst recommendations leads to
  more efficient use of research
• Comparison over time encourages consistent
  approach to portfolio construction

5
What are the current challenges?

• Portfolios with asymmetric return distributions
• Corporate and convertible bonds
• Hedge funds
• Medium-term view of risk not just overnight
  sensitivities
• Insight into interactions between risk factors
• Upside and downside risk, skew, kurtosis
• Simulation-based solutions showing some promise
• Total fund risk
• Accurate measure of risk for balanced funds
• Contribution to risk of asset allocation
  decisions
• Interaction between asset allocation and stock
  selection
• Interaction between stock selection within asset
  classes
• Contribution to risk of tactical asset allocation
  using futures and options

6
An Example
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An Example continued

• Convertible bonds relative to benchmark
• Hypothetical portfolio
• Simulation with complex modelling of bonds
• Shows asymmetry of returns
• Captures skew, kurtosis and other asymmetrical
  features
• Indicates option delta and gamma
• Shows asymmetrical contribution of risk factors
• Including effects of options
• Note more equity upside and more credit grade
  risk on downside
• Indicates portfolio has a higher gamma than the
  benchmark
• Indicates extent of interactions of risk factors

8
Conclusion

• Improved investment performance
• Ensures enough risk is taken
• Risk is targeted
• Disciplined investment process
• Research is used effectively

• Effective Risk Management
• Credible
• Accountable
• Adaptable