22 March 2012

Hedgeweek: Reducing risk dynamically need not negatively impact long-term fund performance, says senior portfolio manager

Managing risk more dynamically is becoming an increasingly vital function of the investment management process. Those that can demonstrate their effectiveness at reacting quickly to volatility are held in high regard. Performance is still vital, that's why investors pay inordinate fees.

However, risk-adjusted returns can improve over time by managers taking a multi-dimensional approach to managing risk as opposed to viewing it merely as a support function.

At least that’s what Dr Matthieu Vaissie, a research associate at EDHEC-Risk Institute and senior portfolio manager at Lyxor Asset Management, and co-author, Serge Darolles, have found in their latest research paper: 'The Benefits of Dynamic Risk Management: mitigating downside risk without compromising long-term growth prospects'.

The paper contains two central ideas. Firstly, that in today’s complex, fast-moving environment risk management can actually become a source of added value provided relevant information is used on an ongoing basis. Secondly, that managers can use this data to construct portfolios that over time will remain well suited to the environment in which they operate.

The methodology involved modelling a series of portfolios with a sample set of data based on the weekly returns of 14 Lyxor hedge fund strategy indices. The sample period chosen was from 4 January 2005 to 28 December 2010, yielding 312 weekly observations. Three portfolios were modelled: a static portfolio, a Garch portfolio, and a regime switching correlation model (SRM) portfolio.

Overall, the research showed that the dynamic portfolio reduced downside risk to a similar extent in both test scenarios. Vaissie concludes that this serves to illustrate that dynamic risk management can indeed add value. In his view, if portfolio managers stop thinking about it purely as risk reduction it will change the way they integrate it into their portfolio construction process: particularly useful for FoF managers - if they can clearly demonstrate the value add of risk management they’ve a good chance of standing out from the rest of the competition.

Vaissie finishes by saying: “Previously, getting more performance involved taking on more risk. We show in this study that it’s not more risk you need. Rather, what you need to do is adjust the level of risk more dynamically to the environment and also adjust the structure of risk on an ongoing basis.”

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