Managers seek a more reliable approach Financial Times 10.2.09 pg.21
Risk Management Ideas based on diversification of assets are being questioned after the strategy became disastrously unstuck last year, forcing funds to look for improved models, writes John Authers, The Future of Investing
...The way in which apparently diverse markets took a synchronized dive last year has shaken up ideas about diversification.
Classically, asset allocation involves making trade-offs between different asset classes. This tends to be labeled "60/40" approach, because many institutions tend to start with a 60 per cent in equities and 40 per cent in bonds.
Last year this approach came catastrophically unstuck, as virtually all of these asset classes fell in unison.
"These models hadn't been stress-tested. They went into it on the principle that this opportunities existed, and there was a first mover advantage. But they had no governance structures and no skill sets to manage these risky assets." says Amin Rajan.
Mohamed El-Erian, head of Pimco, suggests that asset allocation should be about the "risk factors" of different investments, rather than about asset classes. "The same risk factor can apply in different asset classes." he says..."There is also a risk factor, which is public policy. Whether we like it or not, government has become an integral part of markets." ... All look at the risk of outright loss, rather than the volatility of returns.
This requires asset allocators to look at eight different kinds of risk: 1)Concentration risk (the risk that many investors have crowded into the same strategy, making it more prone to sudden busts); 2)Leverage risk (which multiplies both gains and losses); Liquidity risk (the chance that an asset cannot be sold quickly at the prevailing price); 3)Transparency risk (if the investment structure is too complex to understand, Wells Fargo suggests, it is too risky; 4 & 5) Sensitivity to the over-all equity market, and bond market; 6) Event risk (the danger an unforeseen event could pose); 7) Volatility risk (the extent to which returns vary); 8) Operational risk, which includes various risks of businesses failing to perform.
Over the past 10 years the "style box" approach has predominated...splitting funds into nine separate categories, according to whether they used growth or value style or a combination of the two, and whether they invested in small, mid or large cap stock. [fund managers given mandate to abide with a very precise style] ... the achievement of a small-cap value manager beating his benchmark by one percent does not look so appealing of the benchmark is down by 30 percent.
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