By Erik L. van Dijk
The EDHEC Risk and Asset Management Research Centre has done a lot of good work during recent years. Especially in the area of hedge fund research, where it tried to bridge the gap between sophisticated academic work on the one hand, and the use of these concepts in practice on the other. Lately, their work in the area of Asset Allocation has drawn attention as well. In 2008/09 researcher Felix Goltz of the French institute first surveyed a group of almost 300 high level European money managers, and then – based on the outcomes of the survey – contacted them again to discuss the results. The study led to some remarkable conclusions that shed new light on both the quality of players in the industry AND risk management quality during the credit crisis. We can therefore say that the study corroborated findings discussed earlier in this blog.
You can find the full EDHEC paper in the link below (at the end of this entry), but first we will provide you with a summary of the main results.
The main conclusion of the study is a harsh one:
practical applications of portfolio construction/optimization techniques and risk management in the institutional investment world fall short of what has been described in the academic literature as ‘state-of-the art’.
To some extent your author should feel guilty about this, because our Markowitz-Van Dijk framework for risk management and optimization/rebalancing is one of the more advanced systems that are available to practitioners when trying to better manage risk. Actually, MIT professor Mark Kritzman and State Street Scholars Seb Page and Myrgren, wrote a nice paper in 2007 indicating that our methodology was actually superior to other available methodologies. But there are more good systems. What is important is that risk management is not about doing things right whenever we feel like ‘doing another risk assessment’. No, what it is all about is that we apply the technique chosen ALL-THE-TIME and USING THE RIGHT ASSUMPTIONS.
The EDHEC study indicates that there is still a long way to go. Professional money managers do – as a group – apply optimization and risk management tools, but often not the right ones. Or they use the right ones, but use the wrong assumptions, or they do things right, but forget to continuously apply them.
A few of the major mistakes:
How to measure risk? Absolute versus Relative, and What About Outliers?
Optimization of an investment portfolio is about trying to achieve the maximum amount of return for a specific level of risk during a specific investment period. Or, the minimum amount of risk for a specific level of return. With respect to the calculation of returns there isn’t much of a problem. We all know that it is equal to the price return plus percentage dividend (in the case of stocks) or coupon interest (in the case of bonds). More problematic is the derivation of the right risk definition. It turns out that by far the largest group of professionals uses an absolute risk definition, be it the so-called Value-at-Risk (VAR) or the volatility. Absolute risk factors are good when analyzing a portfolio decision, without comparing it to some kind of benchmark. However, professional investors are by definion always invested in something. They could for instance hire our friend King Kong with the darts to manage portfolios or flip coins. The market average of such a strategy would then provide a good benchmark, with the difference compared to this benchmark being the quality/skill (or lack thereof!) of the professional money manager. Strange therefore that only a minority of professionals is thinking first and foremost in relative terms, notwithstanding the fact that folkore (?) within professional circles always explains that wealth management for private investors is about absolute risk and return indicators, with the real institutional professionals focusing on relative return and risk indicators. It is true that professionals do pay special attention to alpha as a measure of excess return (= Return strategy minus Return benchmark) and tracking error (= standard deviation or volatility of the excess return), but somehow they do not integrate this in the optimization or risk framework. They seem to use excess return for the calculation of variable fee (bonus!!!!) levels and tracking error as a kind of constraint (‘avoid tracking errors in excess of x percent’).
VAR and the Normal Distribution of Returns
Another mistake made is that – when applying absolute analysis – the majority is using a Value-at-Risk (VAR) framework while assuming a normal distribution of returns. However, we all know that – during extreme periods like the one at hand – the likelihood of extreme events happening is far larger than what the normal distribution tells us. Normal distribution theory assumes that events that are 3 standard deviations away from the average have a chance of occurence of 1 percent maximum. Events 2 standard deviations away from the average have a chance of occurence of 5 percent maximum and events 1 standard deviation away from the average about one-third. Result: dozens of chief risk or investment officers of even big firms (e.g. Bob Littermann at Goldman) had to tell journalists last year that things that initially were supposed to happen just once every 10,000 years happend two times within a year. In other words: due to the normality assumption there was an underestimation of the ‘fat tails’ in return distributions caused by the fact that people either exaggerate when in panic (excess pessimism) or when too enthousiastic (irrational exuberrance). As a result of the fat tails the value-at-risk is much larger than what can be derived based on the mean and variance. Actually: what is the use of applying VAR when assuming that distributions are normal? In that case the whole distribution is already defined by the mean return and the variance of return!
‘Too complicated for the clients’
Some managers even suggest that they do not apply top-level risk management and optimization techniques because clients don’t ask for them, or would actually not understand them. That is an insane line of reasoning when you would for a second see the investment specialist as a kind of medical doctor trying to cure the financial health of his patient, a.k.a. the client. The average patient in a hospital doesn’t understand anything about Medicine or all the complicated machinery and/or pharmaceuticals used by the doctor. But be sure that patients wouldn’t be too happy if their doctor thinks like this! Thank God it was just a minority of specialists putting forth this line of reasoning. But the fact that alleged professionals dare to think like this is outrageous and indicative of the necessity for increased professionalism within the industry.
The Not-Invented-Here Syndrome
Academic risk and optmization techniques do have a large quantitative component at a level considered difficult by most graduate students or professionals that went for an MBA. It is Ph.D kind of stuff. As so often things that are considered difficult are surrounded with a feel of them being ‘magic’ (at best!) or even ‘pure theory’ (very often!). Result: to the extent that senior management in an investment organization is willing to apply these methods it is too often the case that the one’s that have to decide are not themselves specialists. This creates a feeling of not being totally in control as a result of which there is a preference to use these techniques only when the knowledge is available internally. Why? Well, external specialists cannot be that easily controlled and they are also more expensive. ‘Prudent’ thinking implies that you do not spend too much on things that you don’t totally understand, right? But after some time in this inward-looking culture within the machoist financial industry something else happens. People start to actually believe that they are good internally, not hearing the real specialists (who work outside the firm) anymore and being surrounded within the firm by youngsters that won’t dare to be too critical because that might hurt their career. A so-called Not-Invented-Here syndrome can then set in easily.
The Age- or Vintage-related Knowledge Gap
As long as it is true that senior managers are on average by definition older, with knowledge developments in the young investment science going relatively quick, we will notice that the average younger graduate – still working at lower levels within the organization – is more knowledgeable than the older, senior people. Sure, the older ones have more experience and qualitative knowledge. But risk management and optimization are first an foremost about quantitative skills. And that leads to an age- or vintage-year-related knowledge gap with the ones that probably understand less about risk management and optimization being the ones that have to decide. This is dangerous, and we do strongly believe that to some extent the credit crisis is directly related to this problem. Not to the least, because men have a tendency to be overconfident, as we already indicated in an earlier contribution.
What is New! Sign of Changing Times: Mea Culpa
Not much good news, it seems. However, in one area there was a remarkable difference between the reaction of the top-level professionals to the EDHEC researchers when asked about the survey results now, compared to similar reactions before. Before it was almost standard that – whenever something was academically-oriented or mathematical – practitioners would discard it as being ‘theory’, ‘impractical’ and/or ‘irrelevant’. They would never ever confess that it was too complicated and that they actually did not really understand what it was about. Maybe also due to the credit crisis, and the resulting first indications of some modesty, do we now see that there was something of a ‘mea culpa’ with professionals admitting that they were the ones that were to blame most. There was according to them a big need for additional education. Something that we at Lodewijk Meijer would be pleased to be involved with. But as a kind of mea culpa on behalf of all academics or semi-academics with strong professional roots, we also admit that too often university- or business-school-organized courses were indeed to theoretical. The top scholars never had the responsibility over big multi-asset portfolios that had to be managed on behalf of an end-client represented by a board who applied complex goal functions concerning the way in which the portfolio should be taken care of. And that was difficult, because traditional optimization techniques suffer from the existence of too many constraints. Constraints that are the standard reality of life for practitioners. That is why Harry Markowitz and I myself worked on our new ‘near’ optimization technique, later labeled Markowitz-van Dijk by Kritzman c.s. Scientists with at least some knowledge of hands-on asset management should also try to explain things in a clearer way. But the majority of the professionals with self-criticism made it clear that this was only a secundary reason.
What about the US?
The EDHEC study was primarily about asset management within the European institutional community. What about the US? We said at many occasions that the level of asset management in the US was on average higher than in Europe, and we still believe it is. But even there, the situation is not good but at best mediocre. The focus on stock picking and return is too high, which leads to overconfidence. Results can be improved by better incorporation of risk management and portfolio optimization. It is illustrative how Kritzman’s study indicates that something as simple as efficient rebalancing using Markowitz-van Dijk can easily improve net results by 0.5 percent or more per annum. And that is a lot of money for institutional investors who often have assets under management in excess of USD 500 million. A simple statistical tool can in that case already improve net results by USD 2.5 million per annum! It is therefore not surprising that almost none of the participants in the survey listed ‘costs’ as a prime factor for not applying these modern, state-of-the-art techniques.
Conclusion
Professional money management is an industry under construction. Knowledge levels can and should be improved in a few areas, with risk management and portfolio construction certainly being one of them. Based on the findings in the EDHEC survey it is not surprising that something like the credit crisis could happen. When you are not in the driver’s seat in a risky and changing market, how can you expect to be able to avoid major pitfalls and panics?
It is good to see that the prime actors are at least modest in this respect, something that we did not see sufficiently yet when it comes to bonuses. We are convinced that – with the guidance of the regulators and the interest of the main actors in ongoing education in these areas – improvements are possible. Increased competition between providers, better manager selection by specialized parties who help distinguish between the good and the bad, and interesting opportunities for implemented consultants willing to organize courses will collectively help improve things. But in the meantime end-clients have to make sure that they select professionals that do pay attention to portfolio construction and risk management in a sophisticated manner. Something easier said than done, because of the high abstraction and math levels involved in these applications. Whenever you feel that our support could be of help to you in taking the right decisions in this area, do not hesitate to contact us.
FULL EDHEC RESEARCH REPORT:
edhec_publication_portfolio_construction
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