Category: Financial Risk Management
The 6 Biggest Myths About Diversification and Non-Correlation
“If everything in your portfolio goes up and down at the same time, you have a bad portfolio.” This simple but powerful observation from Mark Rzepczynski, former CEO of John W. Henry & Company, is one I think of often – for both my customers and my own investing. A losing position in your portfolio […]
Auto Loans: The Overlooked Credit Canary
Identifying weakness in markets can be a difficult task. Metrics like gross domestic product (GDP), equity market gains, and unemployment paint in broad strokes. Lenders often try to identify risk at a granular level. This might include tracking payments arriving late, higher credit card balances, increases in line of credit usage, or non-payment of insurance […]
Futures Margin Calls, Explained: Initial vs. Maintenance
A margin call is one of the phrases that scares a new futures investor the most. Often, they picture life savings getting wiped out in seconds, as it does in movies. The truth is not nearly as intimidating. Margin is simply a tool. One that educated investors often love. After all, if you expected your […]
Sortino: A Sharper Ratio
Many traders and investment managers have the desire to measure and compare CTA managers and / or trading systems. Risk-adjusted returns are one of the most important measures to consider since, given the inherent / free leverage of the futures markets, more return can always be earned by taking more risk. The most common risk-adjusted […]
Time-varying correlation – Diversification benefits are dynamic
What is the correlation between two assets? The correlation is critical because it is the driver for any diversification decision. The better question is, “What is the correlation now, and what can it be in the future?”. Correlations are often time varying and regime specific. In bad times, correlations rise, so the diversification expected is not present when you need it. This phenomenon requires more thinking about tail risks and how to best address them.
Credit risk – Profitability more important than leverage
There should be concerns about the amount of corporate leverage in the economy, but if there is no catalyst credit event, current risk is limited. We are not downplaying potential credit risk, but there needs to be focus on the right issues that will drive corporate bonds spreads higher.
Bending the return curve with rebalancing using trend-following
Rebalancing has become an essential tool for portfolio management. Nevertheless, market return patterns will affect the return impact of rebalancing. Regular rebalancing is a mean-reverting strategy. For example, suppose there is a simple 60/40 stock/bond portfolio. In that case, stronger stock performance will cause the allocation to deviate from the strategic allocation and lead to […]
Risk Management – Controlling what you have not thought of
If you have an asset that has some market risk but a large portion that is unexplained, the risks you face are different. You still can either leave the market risk exposed or hedged, but the majority of the risk cannot be explained. Hence, it cannot be truly hedged. You can conduct further analysis to measure the risks from other factors but you may still be left with a high percentage unexplained. You may have thought of everything with respect to your risks, but there is a lot leftover.
Liquidity Risk: Why Every Investor Needs an Exit Strategy
If there is an adverse market move and you want to change portfolio allocations and sell some securities, will you get a fair price? Any downside situations that investors will face will face a liquidity shortage. This is different than thinking about illiquid investments, where the knowledge concerning illiquidity is known. The IMF Global Financial […]
Non-normal distributions – Assume tail risks are higher than normal measurements
If you assume a normal asset return distribution world and it does not exist, you will be surprised with return performance especially in the tails and unlikely for the better. Of course, when in doubt, the rule of thumb for any sample of return data is to assume normality. Using the central limit theorem is a good starting proposition for any discussion, but it is not where the return discussion should end. The distribution assumptions are a place for danger with decision-making.
Are you prepared for a tail event? – Investing for extremes
Everyone is expecting a big negative credit event. Leverage is high. Overall debt is high. Growth is still low. Loose monetary policy continues at extremes through quantitative easing that has supported the extension of the global credit cycle. Nevertheless, the knowledge of a large downside tail event does not mean that investors are prepared with an action plan for when the downturn arrives. Investors can still be unprepared for what they will do with their portfolio when the time comes.
Thinking about skew – Alternative skew measures
I was having a discussion about the merits of managed futures relative to other hedge fund styles. Managed futures funds will often have positive skew versus other hedge fund styles. The measurement of skew is tricky and is not present with all managers but for trend-followers who allow profits to accrue, it is more likely. The argument for positive skew is embedded in the behavior of the managers.
The Balancing of Global Risks – What Do You Need To Do?
The World Economic Forum has produced their Global Risks Report 2019 (14th edition) this week. The report provides an exhaustive listing of the greatest potential threats to the global economy and discusses the potential linkages between these risks. The WEF describes five categories of risk: economic, environmental, geopolitical, societal, and technological. It is worth spending time getting their assessment although be warned that risks are everywhere and not going away. There is no good news with these potential threats.