Sandy Rattray - Strategic Risk Management: Designing Portfolios and Managing Risk

1. Chapter 1
2. Chapter 2
3. Chapter 3
4. Chapter 4
5. Chapter 5
6. Chapter 6
7. Chapter 7

1. Chapter 1
2. Chapter 2
3. Chapter 3
4. Chapter 4
5. Chapter 5
6. Chapter 6
7. Chapter 7

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CAMPBELL R. HARVEY

SANDY RATTRAY

OTTO VAN HEMERT

Copyright 2021 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Names: Harvey, Campbell R., author. | Rattray, Sandy, author. | Van Hemert, Otto, author.

Title: Strategic risk management : designing portfolios and managing risk / Campbell R. Harvey, Sandy Rattray, and Otto Van Hemert.

Description: First edition. | Hoboken : Wiley, 2021. | Series: Wiley finance | Includes index.

Identifiers: LCCN 2021005741 (print) | LCCN 2021005742 (ebook) | ISBN 9781119773917 (hardback) | ISBN 9781119773948 (adobe pdf) | ISBN 9781119773924 (epub)

Subjects: LCSH: Portfolio management. | Risk management.

Classification: LCC HG4529.5 .H378 2021 (print) | LCC HG4529.5 (ebook) | DDC 332.6dc23

LC record available at https://lccn.loc.gov/2021005741

LC ebook record available at https://lccn.loc.gov/2021005742

Cover Design: Wiley

Cover Image: Mike Robinson

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By Martin Leibowitz

Active funds devote considerable effort to the search for excess returns, but risk considerations often fail to get anywhere near the same level of attention. The authors of this book, Campbell Harvey, Sandy Rattray, and Otto Van Hemert, take risk seriously and give it the consideration it deserves.

Risk considerations can get short shrift in many ways. For example, historical returns typically are reported without reference to the risk taken to achieve them. Unfortunately, without a better understanding of the risk involved, it is difficult to estimate the likelihood that such (possibly fortuitous) returns can be repeated.

In the standard risk management approach, the focus is on setting volatility constraints associated with various targets and benchmarks. Such constraints often are based on the probability of a significant downdraft that could adversely impact the current investment strategy. In actuality, the commonality of such constraints across a wide range of funds suggests that some peer group pressure might also be at play.

Once risk limits have been established, managers generally are permitted to roam relatively freely in the search for higher returns. Risk considerations are then relegated to ensuring that returns stay within the pre-established bounds. In effect, this approach tends to put risk assessment in a box that is removed from day-to-day fund management.

In the asset allocation context, this fence-posting behavior is built on the belief that the maximum expected return is equivalent to the optimal return. However, that may not be the case when the funds true objectives are considered.

This books authors make the case that the position of a fund relative to its risk boundaries should be integrated into any consideration of investment shifts. The challenge is garnering sufficient incremental return from new investments to justify all incremental risks.

In theory, each incremental investment initiative or allocation shift should be based on a holistic risk/return valuation. This valuation should include an understanding of the interaction between marginal investment changes and the probability of success relative to various absolute and/or market-sensitive performance goals. An absolute goal might be to achieve a specific return or some given level of spending. Market-sensitive goals might include a desired probability that the funds performance will exceed that of a peer group, market benchmark, or customized reference portfolio.

When such market-sensitive targets are considered, correlations between investment and target returns become important. The incremental return advantage versus a moving target will be improved if the portfolio and the target are closely aligned along the primary dimension of risk.