THE ART OF THE DEAL: A ROBUST RISK MANAGEMENT FRAMEWORK IS A HYBRID OF BOTH ART AND SCIENCE - THE RESULT OF INFORMATION AND INTUITION -

AN ITERATIVE PROCESS - SUCCESSIVE APPROXIMATION

At the end of June 2009, it wasn’t unusual to see most
bond investors looking pale and nervous. After all,
they had just experienced an extremely volatile year in the
market. The last six months of 2008 had produced massive
sell-offs and the first half of 2009 turned in massive rallies.
Trying to suppress their queasiness, investors mulled over
their concerns for the immediate future. Where would
returns come from for the remainder of 2009 and 2010?
And what would be the risk or cost of that return?

The whole experience of volatility also had many
investors asking more fundamental questions about their
approach to the market: “How good is the risk management
process that my portfolio is using?” or, “How good is my
portfolio manager?” and, “What type of risk management
tools do I need to use?”
These are all valid concerns, in stable periods as well as
volatile times. And the answer to all of them lies in the art
and science of fixed-income risk management.

The science of risk management is based on a set of
tenets that have proved effective over time—tenets best
followed through a combination of strong quantitative
risk management systems and a robust investment
process. Measurement techniques that are informative, and
thorough, consistent selection and divestment processes
are simply fundamental to portfolio building.

The art lies in interpreting market conditions, in reading
what the market is saying and acting on it. In this, the past
year’s volatility has been very instructive. The sell-offs of
late 2008 and the subsequent rallies of early 2009 provide
some useful lessons regarding risk management.
To understand how combining the art of interpreting
markets and the science of the selection of individual
securities can help in risk management, let’s review the
turbulent events of 2008/09. We’ll examine them through
the prism of different quantitative measurements, some of
which led to mistakes, and others to sounder decisions.

How Excess Returns Can Fool Models

The first area we are going to look at is excess returns
and how the variance in those returns in recent times led
investors astray. The measurement of excess returns looks
at the degree to which individual securities or sectors of the
bond market underperform or outperform a theoretically
riskless investment, in this case U.S. government bonds.
To take one example, in the second half of 2008, U.S.
corporate bonds underperformed U.S. government bonds
by 20%, the worst negative excess return we have ever
seen. During the first half of 2009, however, U.S. corporate
bonds outperformed U.S. government bonds by 12%. For
the 12-month period then, corporate bonds had an overall
negative excess return of about 8%, calculated simply.

Unfortunately, most corporate bond investors keyed
their risk management models to what happened before
the second half of 2008, with the result that the models
underestimated risk. Had the models been keyed to the
more tail-extreme excess returns experienced between July
2008 and June 2009, risk management would have been
much more closely aligned with what actually happened
in the marketplace. In other words, if these investors
had modified their models (the science) to allow for the
potential behaviour of the market in the first half of 2009
(the art), they might have had better results and certainly
would have enjoyed better risk estimates.

Read entire article:

http://www.investmentreview.com/files/2010/04/The-Art-of-the-Deal.pdf

Jeff Moore
Canadian Investment Review
Winter 2009