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Table of Contents

PART I: OVERVIEW

1. Risk Budgeting: The Next Step of the Risk Management Journey - The Veteran's Perspective
Leslie Rahl

2. Crisis and Risk Management
Myron Scholes

PART II: UNDERSTANDING RISK BUDGETING

3. Risk Budgeting: Managing Active Risk at the Total Fund Level
Kurt Winkelmann

4. The Dangers of Historical Hedge Fund Data
Andrew B. Weisman and Jerome Abernathy

5. Value-at-Risk for Asset Managers
Christopher L. Culp, Ron Mensink and Andrea M.P. Neves

6. Risk Budgeting for Pension Funds and Investment Managers using VAR
Michelle McCarthy

7. Risk Budgeting for Active Investment Managers
Robert Litterman, Jacques Longerstaey, Jacob Rosengarten and Kurt Winkelmann

8. Risk Obsession: Does it Lead to Risk Aversion?
Amy B. Hirsch

9. Market Neutral and Hedged Strategies
Joseph G. Nicholas

10. The Infrastructure Challenge: Empowering the Stakeholder through the Successful Deployment
Gabriel Bousbib

PART III: PRACTITIONERS' THOUGHTS: CASE STUDIES IN RISK BUDGETING

11. Risk Budgeting in a Pension Fund
Leo de Bever, Wayne Kozun and Barbara Zvan

12. Risk Budgeting with Conditional Risk Tolerance
Michael de Marco and Todd E. Petzel

13. VAR for Fund Managers
Stephen Rees

Home > Insights > Risk Budgeting - A New Approach to Investing

Risk Budgeting

A New Approach to Investing

Published by Risk Books, november 2000
Edited by Leslie Rahl, Capital Market Risk Advisors

A practical and authoritative introduction to the concept of risk unit allocation as an alternative and more effective decision-making process for long-term investors.

• Make an informed decision about how to implement and execute a "risk unit allocation" investment policy

• Analysis of techniques to assess how risk might impact long-term Investment returns

• Introduces methods to allocate assets based on the "risk unit" exposures - in individual asset classes and on a portfolio basis, to meet long-term pension obligations and investment return objectives

• Investigates ways to use VAR to accommodate a long-term investment horizon

• Contributions from leading experts drawn from consultancies; large institutional investors; pension plans; investment banks and academia

Leslie Rahl has donated her proceeds from the sale of the book
to the Fischer Black Memorial Foundation.

Book Reviews

Journal of Alternative Investments | Risk Magazine | Hedgeworld.com | Amazon.com

Review of Risk Budgeting:
A New Approach to Investing

Is risk budgeting a risk management technique or a new approach to investing or both? In this three-part, 13-chapter compendium, Leslie Rahl, the editor, and other leading practitioners from the field attempt to suggest that risk budgeting goes beyond the realm of risk management and indeed represents a new approach to investing. In Rahl's own words, the book is "designed to provide a comprehensive assessment of the leading edge thinking on risk budgeting and risk management for institutional investors and plan sponsors." Part I of the book provides an overview, Part II focuses on understanding risk budgeting, and Part III presents case studies.

In the overview, Rahl, a veteran in risk management, traces out the history of risk management and shows that risk budgeting is a natural step toward the evolution of the investment process. She points out that the major difference between asset allocation and risk allocation (risk budgeting) is that the former process emphasizes return, out-performance, and P&L flows whereas the latter emphasizes returns in addition to volatility and correlation. Scholes, the Nobel laureate, discusses misunderstanding of the changing relationship between credit risk and market liquidity. He maintains that risk management is especially crucial to those (e.g. hedge funds) who supply liquidity to financial markets.

In Part II, various authors elaborate their answers to our initial question. For example, McCarthy defines risk budgeting as "the process of allocating an allowable measure of potential loss to different aspects of the investment process, monitoring whether those pieces of the investment process have exceeded their measure, taking corrective measurement process to evaluate risk-adjusted return."

Put another way, risk budgeting is a dynamic portfolio management process whereby scarce resources are put to work to achieve the optimal result. As such, risk budgeting enables an investor to evaluate the portfolio contribution to various exposures to risk. It begins with the determination of current risk exposures to the managers and strategies. Then, it uses the risk measure as the denominator of the risk-adjusted return equation. It ends with risk being used as the basis of "strategic risk management."

Hirsch, an alternative investment consultant, suggests that risk obsession on the part of investors (i.e., obsession with avoiding risk in their portfolios) may lead to risk aversion. She demonstrates with an actual case that it requires more than a few statistics (i.e., standard deviation, Sharpe ratio, or VaR) to create a solid portfolio. Manager, strategy, and style diversification are all important.

Value-at-risk (VaR) is the popular measure of risk exposure in risk budgeting. VaR is defined as the maximum loss a portfolio can incur over a specified time period, with a specified probability. Unfortunately, VaR cannot capture all the risks that may exist in the market. Also, the same portfolio could have very different VaR depending on the methodology that is used to compute it. Thus, McCarthy suggests including results of stress tests as a component of the risk to be budgeted and allotted. Culp, Mensink, and Neves emphasize that although VaR is at odds with asset managers whose primary business is taking risk, VaR can be used to better ascertain whether the risks they are taking are those they want or need to be taking and think they are. To investors, VaR is more a monitoring tool used to prod their fiduciary asset manager toward the regular calculation and disclosure of this measure of market risk.

While Culp, Mensink, and Neves apply VaR to multi-currency asset managers, Winkelmann shows how institutional investors can utilize standard risk and portfolio management tools to systematically manage the risk of a multi-manager portfolio and funds with many asset classes and many managers within each asset class.

Littman, Longerstaey, Rosengarten, and Winkelmann emphasize the importance of including an understanding between the client and the portfolio manager that defines the appropriate range for tracking error (known as the green zone) in a portfolio management assignment. The green zone is the name for the range of risk taking which is agreed upon as appropriate in the context of a portfolio management assignment. They assert that one important measure of the quality of performance is the consistency with which the portfolio tracking error stays within this range. Managers must have skills in managing their tracking error and thus investors may want to monitor the risk management capabilities of a portfolio manager.

As in asset allocation, the risk budgeting/allocation process typically requires statistically derived inputs from the target investments. If statistically derived inputs are inaccurate or systematically biased in some respect, then the optimization process will tend to be flawed and produce undesirable portfolio allocations. This is especially true for certain classes of alternative investments, notably hedge funds. Thus, Weisman and Abernathy introduce a non-parametric factor analysis of a manager's returns that accounts for the shortness of track records, lack of stationarity of returns, and inaccuracy of performance data. However, their model still suffers from two potentially troublesome performance measurement biases: short volatility bias and illiquidity bias.

Without real-time access to information by all stake-holders in an investment, risk budgeting cannot take its full significance. Rounding up Part II, Bousbib discusses the technological framework and considerations necessary to deliver the time-critical risk information to various participants in the investment management community that support the risk budgeting process.

The last part of the book presents three cases regarding risk budgeting. They all relate to the emphases made by other authors in Part II. De Bever, Kozun, and Zvan of the Ontario Teachers' Pension Plan Board describe their experience of using VaR in the pension plan and find that it is a very useful system for dealing with short-term market risk. Moreover, it has also helped the Plan Board and management to understand what risks mean to longer-term planning. More important, they point out that active risk budgeting is the risk that managers take to deviate from the policy mix and that managers are motivated to generate a return on their active risk allocation. De Marco and Petzel focus on the exploration of the hidden assumptions surrounding risk-taking and risk tolerance. They assert that by using "risk budgets" one can stay on top of the investment process, add value where opportunity arises, and maintain appropriate risk exposures. They argue that it is a combination of data quality and skill in interpreting market events that determines the degree of consistency and success. They point out the importance of portfolio construction methods that incorporate this type of risk analysis in achieving the target performance. Finally, Rees argues that the traditional buy-side management tool, tracking error, should be replaced by VaR.

This book is a good reference on risk budgeting and should serve equally well for both risk management and investment professionals. If you are looking for state-of-the-art discussion of risk budgeting, this collection of articles is a must-read. If it is a more practical framework than you are interested in, several examples from real-life situations are provided. As for advanced insights into risk budgeting as well as risk management, this collection has plenty to offer. All in all, this book deserves a place in one's personal library.

A consensus on risk budgeting

Risk Budgeting - A New Approach to Investing

Edited by Leslie Rahl
Risk Books
349 pages, £80
IBSN 1-899-322-94-4

Leslie Rahl's absorbing book, Risk Budgeting - A New Approach to Investing, is a compilation of views from an accomplished list of authors, each of which has contributed substantially to the field of risk management in the past decade. This is one of those rare financial texts that draws the reader in starting with one (of many) thought-provoking sentences of the first chapter - "There has been at least one major market that has moved by more than 10 standard deviations every year for the past 10 years" - right to the last page.

Rahl, the author of a chapter as well as the editor, begins with a veteran's perspective on risk budgeting, "The Next Step of the Risk Management Journey". Drawing from her extensive experience as head of Capital Market Risk Advisors, and previous 19 years at Citibank (nine of which were spent as head of Citibank's North America Derivatives Group), she provides a concise and useful summary of the current state of "risk budgeting". After understanding (or being reminded of) the main concepts in the book's first chapter alone, it is more than possible that the reader will subsequently suffer a bad night's sleep. But do not be put off. As Rahl notes: "Risk in itself is not bad. However, what is bad is risk that is mispriced, mismanaged, misunderstood or unintended." Risk budgeting attempts to understand and minimise these eventualities.

Amazingly, all 21 authors appear to have reached a consensus on what risk budgeting does and does not mean. In "Risk Budgeting for Pension Funds and Investment Managers using VaR", Michelle McCarthy crystallises a definition for the investor: "Put simply, `risk budgeting' is the process of allocating an allowable measure of potential loss to different aspects of the investment process, monitoring whether those pieces of the investment process have exceeded their measure, taking corrective action (if deemed necessary) when a measure is exceeded, and using the risk measurement process to evaluate risk-adjusted return." So: risk budgeting is an effort to answer the question "What if I am wrong?"

The consensus among risk budget advocates is that risk budgeting is not portfolio optimisation and need not interfere with a portfolio's construction. Rather, it is an active attempt to confirm that risks (and their origins) are understood, hopefully before proceeding, in the worst case in assessing what went wrong after the fact.

Because of this consensus definition, the risk budgeting concept presented in this book has a bias towards the application of value-at-risk as opposed to standard deviation or tracking error. That is not to say the latter two estimation methods have no role to play in risk budgeting. For example, co-authors Robert Litterman, Jacques Longerstaey, Jacob Rosengarten and Kurt Winkelman (in "Risk Budgeting for Active Investment Managers") suggest risk budgeting guidelines for tracking error. They offer a useful reminder to the reader that tracking error is currently the lingua franca for communication between asset managers and clients. However, as Stephen Rees points out (in "VAR for Fund Managers"), depending on how it is estimated, tracking error may fail to fully capture the profound misery (or delight) that can be delivered by trending financial markets.

In its 13 chapters, risk issues are addressed at nearly every level, from single investment fund all the way up to firm wide. Two chapters introduce the main subject, providing a good overview of risk budgeting that sets the stage for the contributions that follow. I found all of the contributions to be relevant for fund managers or "quants" in general. At least one chapter focuses on fund-of-fund management, at least four chapters focus on active, alternative asset management, at least two chapters focus on pension fund management and at least two chapters address firm-wide issues. I found no difficulty in reading straight through from cover to cover.

The book contains a thorough index which makes it useful as a desktop reference. Absence of practical exercises and (in at least some cases) insufficient referencing might exclude the book as a classroom textbook.

Risk Budgeting might discuss a number of quantitative risk budgeting tools, but it is not aimed at financial "quants" alone. Myron Scholes' chapter, "Crises and Risk Management", refrains from introducing even one formula or equation! Despite the omission of Greek characters, I found his contribution a deeply thought-provoking piece and a thoroughly interesting story.

Rahl notes that: "Both senior managers and quants play a vital role in risk management." l believe this book will provide a satisfactory and enlightening read for both audiences.

Mark Lundin
Fortis Investment
Management

Risk Budgeting Tradeoffs

By Paul Barr, Reporter
Thursday, May 17, 2001
Book Review

"Risk Budgeting: A New Approach to Investing," edited by Leslie Rahl, New York, RiskBooks, London, 2001, pages, $129, Hardback.

Hedge funds that appear to offer the best tradeoff of risk and return may actually be the worst choice for placing your money.

That's the contention of two contributing authors of the book "Risk Budgeting: A New Approach to Investing," edited by Leslie Rahl, president of Capital Market Risk Advisors, New York.

In a captivating chapter called "The Dangers of Historical Hedge Fund Data," Andrew B. Weisman and Jerome D. Abernathy, make a strong argument that conventional methods for evaluating asset classes can steer institutions into the worst possible alternative strategies.

Understandably, when institutions are confronted with an alternative strategy or vehicle like a hedge fund, they turn to methods they know, like optimization. "It's the wrong thing to do," said Mr. Weisman in an interview. Many alternative strategies at hedge funds don't behave in a linear fashion, a prerequisite for optimization analysis.

Instead, Mr. Weisman advocates a method he developed with Mr. Abernathy to evaluate hedge fund risk called Generic Model Decomposition. GMD seeks to recreate a generic version of a hedge fund manager's investment methods, and then uses that model to estimate risk of the strategy over the long term. GMD allows managers with short track records to be evaluated for the long term. The method combines quantitative and some qualitative research.

Mr. Weisman, who is chief investment officer for Nikko Securities International Inc., New York, and Mr. Abernathy, who is managing partner of Stonebrook Structured Products LLC, New York, also said two core lessons regarding hedge fund investing were revealed when developing GMD.

For one, certain classes of hedge fund managers use methods that carry hidden short option exposure, leading investors to allocate too much to that class when using optimization techniques. Implicit short options exposures can lead to high Sharpe ratios—suggesting that the investment offers a good tradeoff of risk and return. But in reality, one of the infrequent "volatility events" linked to that strategy has not yet occurred, so risk is improperly measured on the downside. Once that event occurs, or by simulating the strategy using GMD, a more accurate measure of risk can be identified.

Moreover, hedge fund managers tend to understate the volatility of their portfolios by way of inaccurate pricing. It's not that hedge fund managers are trying to deceive, it's just that many of the illiquid securities and positions they hold are difficult to price properly. Risk calculations based on market values may then be understated. (Mr. Weisman recently presented a well-received paper with a related theme to the Institute for Quantitative Research in Finance, known as the Q Group.)

For hedge fund professionals, the chapter by Messrs. Weisman and Abernathy alone makes the book a worthy read. The authors essentially point out what could be a fundamental flaw in the way hedge funds manage assets for institutional investors. Ignore it at your own risk.

Value at Risk

The rest of the book, which is aimed at institutions, is more typical of financial compilations, offering explanations and discussions of the basics and a little more. Among the highlights: Ms. Rahl offers a strong synopsis of the state of Value at Risk. There are no great revelations in her opening chapter, but she provides the proper, broad perspective needed for such a book.

Michelle McCarthy, managing director for Deutsche Bank, contributes a clear-eyed guide for using Value at Risk at the customer level. Ms. McCarthy punches holes in some misconceptions about VAR—such as that VAR can only be computed for short-term holding periods—and points to the specific risks investors should be managing.

A group of authors that work in the Research and Economics department of the Ontario Teachers' Pension Plan Board, North York, show how VAR can be applied in the real world. Leo de Bever, senior vice president, Wayne Kozun, director, and Barbara Zvan, director, describe how the Ontario pension fund budgets and allocates risk among its portfolio managers. The authors deserve recognition for writing about a dry subject in an interesting fashion.

Similarly, Michael de Marco, senior vice president for Putnam Institutional Management, Boston, and Todd E. Petzel, president and chief investment officer for Commonfund Asset Management Co. Inc., Wilton, Conn., deliver a readable and practical guide for institutional investors seeking to use VAR.

Other chapters offer VAR insights in a useful, if textbook-like, fashion. But disappointingly, the book includes a number of reprints from articles seen elsewhere, including Risk Magazine, sister-company to the publisher, Risk Books. While that doesn't diminish any value those articles have at an absolute level, anyone who's keeping up on the topic may be disappointed if they've read any of the reprinted chapters before.

Chapter 9 in particular stands out as a case of padding the page count. Though by far the longest chapter in the book at 74 pages, "Market Neutral and Hedge Strategies" previously appeared in "Market-Neutral Investing: Long/Short Hedge Fund Strategies" by Joseph G. Nicholas, founder of the HFR Group of Companies in Chicago.

Given the constantly changing nature of Value at Risk, Risk Budgeting offers solid perspectives on managing risk plus the provocative chapter on hedge fund performance. At a cost of $129, you may question the price given the number of reprints. (Ms. Rahl has pledged any proceeds she receives from the book to the Fischer Black Memorial Foundation.)

Nonetheless, the book can give VAR neophytes a glimpse into the complicated world of risk management; while more advanced practitioners can use it as a reference to call upon when structuring their own VAR programs.

Novel approach to risk budgeting and asset management, March 5, 2001

The book provides a delightful insight into the intricate world of balancing the trade-off between risk management and higher returns. This book is meant for those either alreday in the industry or those that have a strong interest in the day to day management of large funds. A glimpse of the authors in the book would please any academician -- MIT, Harvards, Stanfords, PhD's, CFA's... The content is varied and at the cutting edge of asset management -- a must read for any interested in an academic, risk managed approach to the world of asset management. Higher returns are not guaranteed, and the book will be too complex for many, but for those with some background it's a worthwhile splurge.