Qontigo published a research paper, Getting a better read on portfolio risk-return metrics by Olivier d’Assier, head of APAC Applied Research at Axioma. Axioma is a Qontigo company, which is a global index (STOXX and DAX) and data analytics provider and part of the Deutsche Börse group.
The paper addresses the need to distil complex risk management data into actionable insights for investors. It operates under the assumption that investors differ from gamblers by making favorable bets, risk and reward can be represented by mean and standard deviation metrics, and the ex-ante Information Ratio (IR) is a suitable measure of long-term risk-reward trade-offs. It combines quantitative analysis and probability theory to classify investment opportunities and proposes a risk budgeting framework based on market conditions.
The paper asserts that investors should quantify their investment goals and define their objectives with regards to both the returns they seek to gain as well as the risks they are willing to take in acquiring them. Portfolio selection should then follow a systematic process of projecting each option’s risk-return profile and ensuring the final choice is aligned with the investor’s risk tolerance.
Selecting a portfolio simply based on its probability of outperforming implies an infinite supply of trials, which isn’t the case for most investors. Once the savings run out, the trials stop. Using the risk profile of each option to calculate the upside potential AND the downside risk can help ensure sure the asset owner and portfolio manager are comfortable with both, leading to a greater chance of success.
In investment, it is easier to live with the regret of the opportunities you didn’t go for, than the remorse from the losses of the ones you did; the latter might be a choice you relive over and over again for the rest of your life. A manager’s skill level remains fairly constant over short periods of time, but the risk environment can rapidly change and the market will pay vastly different rewards for risk-taking at different times.
Managers need to ensure that their risk budget is in tune with the risk environment in the market at each rebalancing. Understanding the nature of the opportunity will also help managers and investors structure investment mandates with a higher probability of success, for both sides, during negotiations.
In the words of Fred Schwed Jr., “Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investing is an effort, which should be successful, to prevent a lot of money from becoming a little.” For the latter to be successful, it requires both discipline and transparency. Headline risk characteristics can be used to design a framework such as the ones discussed above, to provide investors with a kind of confidence intervals around their expected investment outcomes. When reality confounds probability, it’s time to ask more probing question.