Portfolio Risk Control: We Are All Blind Before We See

By Ferris Eanfar, Managing Partner, Vision Bancorp

It’s All About Risk Control. Portfolio Risk Control

How do you “control risk”? Unfortunately, most asset and money managers don’t fully understand how to effectively control risk in their client portfolios. They may say they “manage risk” or “measure risk” or “analyze risk” and they may use impressive technical jargon, but the majority of financial advisors, money managers, traders and portfolio managers don’t understand how to quantify and control risk in real-time. If you can’t actually control risk in real-time, then all the typical risk management jargon and back-testing analysis is a waste of time and resources. Vision Bancorp’s team has a long history of revolutionizing financial service industries; so we know something about controlling financial risks by building market-leading financial services technologies that solve real-world challenges. In this article we will explore how investors and their portfolio managers can quantify, measure, monitor, manage, and control risk in real-time.

What is Risk?

This should be a very simple question with a very simple answer, but most people make it much more complicated than it needs to be. In the context of investment portfolio management, “risk” is simply the possibility of losing money. (Note: Losing purchasing power is implicitly included in the phrase “losing money”.) This reality can be easily observed by recalling the natural questions that people instinctively ask when they are considering a financial investment of any kind. For example: “What’s the risk of a bad investment?” The answer is “losing money.” Or “What’s the risk of inflation?” Losing money. “What’s the risk of a collapse in the stock market?” Losing money. “What’s the risk of interest rates rising/falling?” Losing money. “What’s the risk of getting bad investment advice?” Losing money. In all conceivable investment scenarios, the risk is always pure and simple: Losing money.

How do You Avoid Losing Money?

This is the real question, which requires a bit more time and attention to the details. To avoid losing money you need to follow a straight-forward process:

  1. Identify Risk. Market risk, liquidity risk, price risk, inflation risk, systemic risk, political risk, interest rate risk, underlying company performance risk, model risk, credit risk, environmental risk, counterparty risk, margin call risk. . . . Risk Managers around the world can easily identify many risks. How many of these risks can influence the performance of your portfolio? All of them. How many of these risks can you really control? None of them. What! . . . If we can’t control any of those risks, how exactly does a Risk Controlled Asset Management System work? Simple, there’s only one risk you need to effectively identify and control: Money Manager Risk.

  2. Measure Risk. You have your money manager in your cross-hairs, now it’s time to perform some mathematical analyses on your money manager’s historical performance data using algorithms and formulas that would probably give Stephen Hawking a mental challenge. (I said the process was “straight-forward”, not easy.)

  3. Monitor Risk. After every trade made within your trading account(s), compare the ongoing outputs from the previous step to relevant benchmarks over a defined period of time to detect deviations from your money manager’s expected and/or desired performance.

  4. Risk BudgetCreate Risk Budget. Define a “Risk Budget” as a percentage of the cash value of your portfolio, which defines exactly how much of your portfolio you are willing to lose to achieve a given rate of return. This is the opposite of how most money managers and investors think. So pay close attention to the following question because this principle is the deceptively simple and profoundly important core of the entire Portfolio Risk Control and Risk Optimization Process: What rate of return are you willing to accept per unit of drawdown risk? In this context, “unit of drawdown risk” would be any currency unit, e.g., Dollar, Euro, Renminbi, Yen, Rupee, etc., used to measure the maximum peak-to-trough decline in an asset’s value within some defined period of time during a money manager’s historical performance.

  5. Allocate Risk. Based on the analytical steps above, and with a clear understanding of your Risk Budget, allocate a portion (or all) of your portfolio to the money manager(s) whose maximum drawdown has never exceeded your Risk Budget. This process can be as simple as finding a money manager who has never had a drawdown of more than 10% during the previous 10 years; or as complicated as engineering an entire blended, risk-weighted, multi-asset-class portfolio with hundreds of money managers, strategies, fund-of-funds and corresponding aggregated individual Risk Budgets. Although allocating risk and corresponding funds across a large multi-manager portfolio can get complicated, the Risk Budget dramatically simplifies the process for portfolios of any size. However, the real magic comes next.

  6. Control Risk. Armed with your Risk Budget, your automated analytical systems humming, your performance reporting tools aimed menacingly at your money manager, and decades of financial trench warfare experience to guide you, you’re now able to hold your money managers strictly accountable to your individual Risk Budget. Actually, in my firm’s case the whole process is easy because it’s fully automated using our real-time Omni-Sector Countertrend Algorithmic Risk-Controlled Asset Management System (Yes, the technical name is ridiculously long so we simply call it “OSCAR"™.) to automatically detect in real-time whenever any money manager connected to OSCAR™ reaches a client’s Risk Budget.

  7. Automate Risk Control. Using an automated Risk Risk Management Performance ChartControl Asset Management System, as soon as the client’s Risk Budget is reached, an alert should be sent to the client and to the Relationship Manager in the firm who’s responsible for the client, and then the money manager is instantly blocked from trading anymore of the client’s funds. At that moment, the client can select another money manager with a Risk Budget that’s more appealing or the client can liquidate the portfolio, withdraw the funds and spend some time on the sidelines until the client finds another money manager with a more compelling Risk Budget. In a well-managed firm, the entire risk control process can occur within minutes, including protecting the client’s portfolio from poor performance, re-allocating the funds to a better performing money manager, and even re-balancing the entire portfolio to exploit new opportunities in any exchange-traded market.

A Journey of a Thousand Trades Starts with Effective Risk Controls.

In the mid-1800s the travel time required to ride a horse over the treacherous Oregon Trail across the United States was six months. Today the same distance only takes six hours by airplane. When it comes to portfolio risk management, most money managers are still wandering aimlessly on the Oregon Trail, exposed to myriad risks that threaten their livelihoods every day. The money managers who know how to measure and control portfolio risk in real-time have an unfair advantage because they can manage much larger portfolios and efficiently serve many more clients, which means they can earn more and/or work less and enjoy more time with their families at home.

The portfolio risk control process is not complicated to understand conceptually, but no matter what anybody tells you, if they don’t have a system that automatically enforces a Risk Budget against the money manager’s real-time performance, they are not controlling portfolio risk. If this approach to portfolio management seems complicated to implement, you’re right, but only if you’re wandering down the old Oregon Trail of portfolio management.

Managing a Portfolio Without a Risk Budget is the New Definition of Insanity.

Einstein said, “The definition of insanity is doing the same thing over and over and expecting different results.” By that definition, there are many insane portfolio managers repeatedly exposing their clients to the same risks year after year and expecting different results. This helps to explain why so many money managers are struggling to generate alpha for their clients despite the persistent buoyancy of the equities market. It’s not that some money managers don’t occasionally have good years, it’s that they rarely have consistent performance over any significant period of time because they get sloppy, fall prey to style drift and other gotchas that erode their performance. This is why managing a portfolio without a Risk Budget is like driving a car down the freeway without a break pedal. Sooner or later you and your clients will crash.

Looking Back to See the Future of Portfolio Management.

My firm’s asset management team built our real-time risk control system because it felt like we were on the Oregon Trail as all the usual money management risks were flying at us at the speed of a 21st Century globally connected world. After we fully automated the processes for our internal asset management needs, we realized that a fully automated risk-controlled and risk-optimized portfolio management system would inevitably change the way all portfolio managers run money. Revolutions don’t happen overnight so don’t expect your financial advisors to understand how to use and enforce a Risk Budget in real-time on their own, but ask yourself this simple question: “If ‘risk’ simply means ‘the possibility of losing money’, and if I don’t want to lose money, then why would I allow my portfolio to be managed without a real-time Risk Control System automatically enforcing a Risk Budget?”

We Are All Blind Before We See.

See the light of automated Risk Control.Those who embrace the light of truth usually see the path to prosperity much faster than those who dwell in the dim rituals of the past. It may not be today or tomorrow or next week, but at some point in your future, your portfolio will inevitably get bombed by something that some trader or money manager will vigorously describe as a Black Swan. At that moment, you will hear the echo of these words in your head. You will begin to yearn for a futuristic world where portfolio risks are tamed, money managers are held accountable for their performance, volatility is less fearsome and returns are more consistent, the banking system is less vulnerable to cowboy traders, and the global community of investors and their portfolio managers can breathe a collective sigh of relief knowing their assets are being managed responsibly and consistently. Indeed, the future of real-time risked-controlled portfolio management looks bright . . . .

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About the Author:
Mr. Eanfar is a Managing Partner at Vision Bancorp, which specializes in commodities-backed asset management, commodities trading. His professional experience spans diverse environments including technical development, media, finance, military and government affairs. Mr. Eanfar can be contacted at the website: https://visionbancorp.com.

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