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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


Next generation investment risk management1
Next Generation Investment Risk Management

Company confidential


Modernized modern portfolio theory

Next Generation Investment Risk Management

ModernizedModern Portfolio Theory

Company confidential


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


Correlation does it measure what matters
Correlation — does it measure what matters?

Company confidential



To copulas
…to copulas

Company confidential


Dynamic asset allocation

Next Generation Investment Risk Management

Dynamic Asset Allocation

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 exploit riskis 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 does this strategy compare to the s p500 total return index
How does this strategy compare exploit riskto the S&P500 Total Return Index?

Company confidential


How does this strategy compare to the s p500 total return index1
How does this strategy compare exploit riskto the S&P500 Total Return Index?

Company confidential


How else did we test this strategy
How else did we test this strategy? exploit risk

  • Rolling annual returns

  • Maximum drawdowns

  • Parameter robustness

Company confidential


This strategy can be continuously improved upon
This strategy exploit riskcan 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


Enlightened tail risk hedging

Next Generation Investment Risk Management exploit risk

Enlightened Tail Risk Hedging

Company confidential


Our three criteria for an effective buy and hold tail risk hedge
Our three criteria for an exploit riskeffective 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 exploit risk

  • 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? exploit risk

  • 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 exploit risk

Company confidential


Some combinations are promising
Some combinations are promising exploit risk

Company confidential


The combined effect can be game changing
The combined effect exploit riskcan be game-changing

Company confidential


Next generation investment risk management2
Next Generation exploit riskInvestment Risk Management

Company confidential


For further reading on these ideas
For further reading on these ideas… exploit risk

Company confidential


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