June 11, 2012 – You weathered the credit crisis. You got through the Flash Crash. You are watching Europe (and the U.S.) struggle to make sure its debt doesn't implode from the global economic downturn. So you're ready for the next big threat to financial markets, right?
Maybe not. It's harder than it sounds, say risk experts, who believe many stock funds still lack tools to prepare for and weather fluctuations.
"There is too much lip service being paid here without any real follow-through," says Nathan Lee, lead portfolio manager at the quantitative hedge and mutual fund firm Hagin Investment Management. "Almost four years since (the disappearance of) Lehman Brothers, headlines still suggest there are risk managers at systemically important firms that are merely figureheads or lack any power to manage risk before the trade."
Any risk management strategy worth its salt forces managers to think about the subject at every stage of their investment process, from brainstorming to asset allocation, say experts. That means not just calculating how much of a portfolio is at risk of being wiped away in the next 30 days, the end of the week or even the day. Now, risk management means spending on technology such as real-time risk modeling, among other tools.
"Managers need to be able to monitor and manage positions and exposures across multiple markets, real-time," says Phil Lynch, president and chief executive of the data management firm Asset Control. "The industry is nowhere near where it needs to be on this. Everyone is behind."
And, oh yeah, there's no such thing as too much research. Looking behind risk numbers and economic statistics is essential.
"Building a team of individuals who see a share of stock as a fractional ownership of a company has a big impact on risk management," says Lee. "A firm that is oblivious to the quality of a company behind a stock is doing a bad job of managing risk, although it may have the biggest software budget."
How to increase risk awareness, whenever and wherever possible? Consider the strategies of Stadion Money Management, a privately owned $5.4 billion asset manager near Atlanta. The Stadion process is governed by a technical model that produces a measurement it calls the "Weight of the Evidence.'' It includes nine statistical indicators, called components, which get scored, weighted and added to the overall measure.
These range from factors such as stock price trends and comparisons between advancing and declining stock issues to help managers pinpoint market movement, says chief investment officer Brad Thompson.
"Our model helps us understand when the sun is shining and the investing probabilities are in our favor or when the clouds are forming overhead and we need to be prepared to seek shelter," he says.
For example, one important component is called "trend capturing," which is composed of three calculations: Stock price movements, up and down; trading volume; and the number of advancing versus declining issues. The first calculation, when positive, indicates an upward price trend. The second and third calculations confirm the trend and determine if it's solid.
Another component is called "relative strength." This is designed to measure sentiment: i.e., are investors actively taking investing risk or have they turned bearish? It's also derived from three calculations related to investing involving stocks with small market capitalizations versus large ones; growth-oriented stocks versus value-oriented issues; and measurements of breadth of interest and prices.
The core of that component: When small caps outperform large caps, investors generally have higher risk appetites.
Each component is assigned a weight, from five to 25 points, and then totaled. Total score ranges have separate color coding, like red for scores between 0 and 30, and green for 80 to 100. Each color spurs a particular set of rules for buying and selling, etc.
At Snow Capital Management, managing director David Jack says his firm's most potent risk tool is its fundamental investment process, geared at finding attractively mispriced stocks. He says his firm constructs diversified portfolios of good, financially strong companies where the stock price is depressed because the company has experienced temporary difficulties of some sort."
This philosophy relies on independent research to determine the nature of the company's problem, assess the likelihood of a solution, and then determine whether the company can survive the difficulty.
Jack argues the downside is protected because the stock price is: already depressed; the company is sound; Wall Street's opinion is already negative, and investor expectations are low.
"Our investment process keeps us from investing in a bad business (at any price) and from paying too much for a good business,'' Jack says.
Franklin Templeton Investments is another company that relies on fundamental drilldowns into the health of companies to gauge risk- but it also tries to harness it.
"Risk and return are like two sides of the same coin, and you can't have one without the other," says Wylie Tollette, Director of Performance Analysis and Investment Risk.
Tollette says that Franklin's risk philosophy is not to avoid or eliminate risk, but rather to seek risks that are: recognized, i.e. well understood, measured and communicated; rational and appropriately sized in relation to the fund's investment mandate, and of course, rewarded.
To illustrate these principles, Tollette gave the example of owning shares in an Australian mining company. One might intuit the performance of those shares would be influenced by the company's operating fundamentals, as well as the performance of the Australian market and economy. Top down analysis might show that many mines are influenced by emerging market growth. The goal, he said, "isn't to avoid that specific emerging market exposure, but to ensure it is recognized, sized rationally in the portfolio and that the additional volatility it could add is compensated over the long term through return."
Everyone is behind...