Investment Quality Control: The Importance of Risk Management

Consumers like to get what they pay for. When they purchase a carton of milk at the market, they are usually unhappy if they subsequently discover apple juice in the carton. Clients who hire an investment manager are no different. Someone who invests in a small-cap growth fund does not wish to own alarge-cap value portfolio.

In this context, risk management is best understood as investment quality assurance. It helps assure that milk gets into the container rather than apple juice. It does not, however, ensure that the investment product has a positive return or exceeds a benchmark index return.

The Traditional Approach: False Security

One of the earliest forms of risk management, developed several decades ago, is the investment guideline—a document that, among other things, limits the percentage of a portfolio that can be invested in any single stock, industry or sector. Additional restrictions may include specifics such as the market capitalization of the stocks to be included in the portfolio.

Investors frequently view the investment guideline as a means of safeguarding their assets. However, in certain cases, a portfolio manager may follow the letter of an investment guideline without meeting its original intent. For example, an investor looking for the relative safety of a large-cap core fund may invest in a fund or a portfolio restricted to the companies in the S&P 500. But the S&P 500 is not a listing of the largest 500 companies in the market. It is a representative sample of leading U.S. companies operating in leading industries. Therefore, a portfolio manager could theoretically use the stocks in the S&P 500 to construct a mid-cap portfolio and still be within the guidelines.

Financial theory has advanced greatly since the advent of the investment guideline, and recent technological advances enable modern investment managers to complete complex calculations with ease. Many investment guidelines, however, have not evolved and are nearly indistinguishable from those used back in the 1950s and 1960s. The problem is that these guidelines can leave loopholes that give portfolio managers the latitude to take on more risk than the investor originally intended.

In order to guard against such behavior, investors would be better served by incorporating modern quantitative techniques to measure and manage risk.

The most common quantitative tools used today are tracking error, factor exposure and value at risk.

Tracking Error

Tracking error is a measure of the riskiness of a portfolio relative to its benchmark index. Put differently, it is the fluctuation in the difference between the portfolio and the returns of its benchmark index. It is measured both ex-post (actual tracking error based on observed historical returns) and ex-ante (predicted future tracking error). A larger value implies greater portfolio risk relative to the benchmark. Thus, an investor can better manage risk exposure by setting a maximum allowable tracking error.

Figure 1. Tracking Error vs. Sector Deviation CLICK ON IMAGE TO SEE FULL SIZE.

There are several factors that affect the level of tracking error in a portfolio, but three are of particular importance. The first is the number of stocks in a portfolio. Tracking error moves inversely with the number of stocks held. In other words, the impact of one stock’s movement is greater in a portfolio with only two stocks than in one with 100 holdings. For example, an investor with a 15-stock portfolio, which translates to approximately 8% tracking error, is taking a fair amount of risk relative to the S&P 500 index.

The second factor is the market capitalization and style of the portfolio (i.e., growth, core or value). As Table 1 indicates, an equity manager using the S&P 500 as a benchmark, and operating under a tracking error guideline of 5%, would not be able to transform the portfolio into a mid-cap value portfolio because the tracking error would be 7.65%. As previously noted, a manager without the restrictions of a 5% tracking error could create a mid-cap value portfolio from a subset of the stocks in the S&P 500 index and still remain within the letter of the investment guidelines.

The final factor affecting tracking error is the sector weighting. Traditional investment guidelines often limit the percent that can be invested in any one sector or industry. Frequently there is also a reference to the maximum sector or industry weighting relative to the benchmark index. Changes in these sector weights can have a dramatic effect on tracking error. As shown in Figure 1, a portfolio with average absolute sector deviations of 4% has a tracking error of 8%. This means that a portfolio may overweight health care by 4%, underweight consumer staples by 4%, overweight energy by 4%, underweight financials by 4%, etc., and have the same amount of risk as a portfolio with only 15 stocks. They both would have a tracking error of 8%. Here again, traditional investment guidelines are providing a false sense of risk management.

Factor Exposure

Another quantitative technique that can be helpful in managing risk is factor exposure, which measures the sensitivity of a portfolio to a set of variables that explain equity returns. Factors that are frequently identified include systematic risk (historical performance relative to an index), valuation, momentum, market capitalization, financial leverage, dividend yield, foreign sensitivity, and liquidity.

The factor exposure report in the example in Table 2 indicates that the portfolio has a higher valuation than the benchmark index, expressed as negative numbers in the Active Risk column in the rows Book-to-Price Ratio and 12-Month Forward Earnings-to-Price Ratio. The portfolio has higher exposure to growth factors, expressed as positive numbers in the Active Risk column in the rows Momentum, Long-Term Earnings Growth, and Forecast Earnings Yield Revision.

A factor exposure report can be used by an investor to determine whether a portfolio manager is following the investment style set in the investment guidelines. Two key styles are growth and value. Typically, portfolios with significantly higher earnings growth than the index are characterized as growth-style portfolios. Because the valuation is also slightly higher than the index, such a portfolio is sometimes referred to as core growth, or to some investors, an aggressive growth style. If an investor has hired a growth-style manager, then a factor exposure report similar to our example would be consistent with the investor’s expectation.

However, if the investor hired a value-style manager, then the report in our example would cause some concern. Value investors seek stocks that they believe the market has undervalued. Often, they select securities with above-average book-to-price and earnings-to-price ratios. And they are less concerned with higher earnings growth. Therefore, negative active risk numbers in the valuation factors, along with the high active risk numbers in the growth factors, could raise concerns that may have been undetected by the investment guidelines alone.

Value at Risk

A third method of measuring risk is value at risk (VaR), which estimates the worst expected loss over a given period, under normal market conditions and at a chosen confidence level. Put another way, it provides an aggregate view of the risk of a portfolio, taking into account leverage and correlations. In the Table 3 example, the VaR report shows the worst expected loss over a one-month horizon, and at a 1% probability of loss, to be 7.4% of the total portfolio market value or $7,733,706. This is simulated by using historical portfolio volatility data to project future returns and calculate confidence levels—probabilities of a given return. An investor with a higher risk tolerance would be more comfortable with a higher VaR than a more risk-averse individual would be.

The strength of VaR is that it is a single statistic. However, the singularity is also a drawback. It provides much less information about the portfolio than the factor exposure report. Therefore, VaR is best used in combination with other risk measurements.

More Effective Risk Management

Traditional investment guidelines can provide a false sense of security to investors. A portfolio can fit within the guidelines, and yet have significantly higher risk and a different style than the investor desires.

More effective, modern quantitative measures do not focus on sector or market capitalization restrictions. Instead, they focus on tracking error, and they may also measure risk in a factor exposure report that is consistent with the style advertised by the manager.

The combination of tracking error and factor exposure measurement should provide the investor with a more accurate way of assessing the risk level of their equity portfolio.

By using the risk measures suggested here when evaluating their portfolio’s performance, investors would be more likely to achieve the optimal portfolio that they used to set up their asset allocation