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Next Generation Investment Risk Management . Annual Conference May 23, 2012. Jerry Miccolis CFA ® , CFP ® , FCAS, MAAA. Next Generation Investment Risk Management. Next Generation Investment Risk Management. Modernized Modern Portfolio Theory. Modernizing MPT.

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next generation investment risk management

Next Generation InvestmentRisk Management

Annual

Conference

May 23, 2012

Jerry Miccolis

CFA®, CFP®, FCAS, MAAA

modernizing mpt
Modernizing MPT
  • More realistic asset distributions
    • Non-normal/fat tails
  • More representative investment horizons
    • Multi-period/compound returns/risk drag
    • Rules-based rebalancing
  • More meaningful risk measures
    • Shortfall risk
    • Conditional VaR
  • More useful dependency measures
    • Correlations  copulas

Company confidential

correlation it gets the obvious cases right
Correlation — it gets the obvious cases right

ρ = +1

ρ = -1

Company confidential

to copulas
…to copulas

Company confidential

daa is a more proactive way than traditional rebalancing to exploit risk
DAA is a more proactive way than traditional rebalancing to exploit risk
  • Dynamic asset allocation
    • Explicitly treats momentum/mean reversion
    • Utilizes early warning signals
  • Signals can be internal and external
    • Moving average algorithms
    • Valuation measures
  • DAA reflects the fact that MPT is only as good as its inputs
    • Recognizes that inputs can change dynamically
    • Structurally sound way to:
      • Test your fundamental inputs
      • Nimbly make adjustments as appropriate
  • Leading Economic Indicators
  • Credit spreads/money flows

Company confidential

our sector rotation strategy is an example of daa
Our sector rotation strategy is an example of DAA
  • Stable-weighting
  • Exit/entry signaling
    • Trade-offs between stability and responsiveness
    • Three “momentum” algorithms
      • Each has its own strengths/ weaknesses
      • Rules that determine which algorithm to use at different times
      • Dynamically move between responsiveness and stability based on market characteristics
  • Filtering
    • To avoid too-frequent trading
  • Parameters optimized based on 1990-2007 data
    • Tested “out of sample” with 2008-2011 data

Company confidential

how else did we test this strategy
How else did we test this strategy?
  • Rolling annual returns
  • Maximum drawdowns
  • Parameter robustness

Company confidential

this strategy can be continuously improved upon
This strategy can be continuously improved upon
  • Stable-return investments in lieu of cash
  • Tactical moves into volatility
  • LEIs and other external signaling
  • Expand beyond US large-cap equity sectors
    • Global/international sectors
    • Commodities and other alternatives

Company confidential

our three criteria for an effective buy and hold tail risk hedge
Our three criteria for an effective buy-and-hold tail risk hedge
  • Sudden appreciation in severe market downturns
    • “Severe” denoting sudden, substantial, unexpected decline in market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn’t help)
    • Appreciation to a degree sufficient to meaningfully offset the decline
    • No “give-back” during market recovery!
  • Very low cost
    • Minimize diversion of funds from productive use
    • No sacrifice of upside portfolio potential!
  • Minimal disruption to portfolio
    • Maintain what works in vastly more likely markets
    • “Don’t throw the baby out with the bathwater!”

Company confidential

our criteria helped narrow our search
Our criteria helped narrow our search
  • Traditional direct protection (e.g., puts, collars) violate our criteria
  • “Black Swan” funds violate our criteria
  • Promising idea: Exploit volatility spikes that coincide with sudden market declines
  • But, long-only volatility (e.g., VIX) violates our criteria
    • Transitory benefit
    • Can’t invest in directly
    • VIX futures: Severe negative roll yield  very high carry cost

Company confidential

does anything meet our criteria
Does anything meet our criteria?
  • Dynamic hedging
    • Puts/put spreads/VIX futures opportunistically applied
    • Needs constant monitoring
    • Potentially high cost
  • Correlation plays
    • “Call-on-call” strategies
    • Not yet well developed
  • Long/short volatility plays
    • Realized volatility: daily vs. weekly
    • Implied volatility: medium-term vs. short-term
    • Spread: implied vs. realized
  • Combinations

Company confidential

our criteria in a picture
Our criteria in a picture

Company confidential

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