SUMMARY

• Make an informed decision about how to implement and execute a 'risk unit allocation' investment policy

• Analysis of techniques to assess how risk might impact long-term investment returns

• Introduces methods to allocate assets based on the 'risk unit' exposures - in individual asset classes and on a portfolio basis, to meet long-term pension obligations and investment return objectives

• Investigates ways to use VAR to accommodate a long-term investment horizon

• Contributions from leading experts drawn from consultancies; large institutional investors; pension plans; investment banks and academia

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  TABLE OF CONTENTS

CONTENTS

Introduction
Leslie Rahl

Part 1: OVERVIEW

1 Risk Budgeting: The Next Step of the Risk Management
Journey - The Veteran's Prospective
Leslie Rahl

2 Crisis and Risk Management
Myron Scholes

PART 2: UNDERSTANDING RISK BUDGETING

3 Risk Budgeting: Managing Active Risk at the Total Fund Level
Kurt Winkelmann

4 The Dangers of Historical Hedge Fund Data
Andrew B. Weisman and Jerome Abernathy

5 Value-at-Risk for Asset Managers
Christopher L. Culp, Ron Mensink and Andrea M.P. Neves

6 Risk Budgeting fore Pension Funds and Investment
Managers using VAR
Michelle McCarthy

7 Risk Budgeting for Active Investment Managers
Robert Litterman, Jacques Longerstaey, Jacob Rosengarten and Kurt Winkelmann

8 Risk Obsession: Does it Lead to Risk Aversion?
Amy B. Hirsch

9 Market Neutral and Hedged Strategies
Joseph G. Nicholas

10 The Infrastructure Challenge: Empowering the Stakeholder through the Successful Deployment of Technology and Data
Gabriel Bousbib

PART 3: PRACTITIONERS' THOUGHTS: CASE STUDIES IN RISK BUDGETING

11 Risk Budgeting in a Pension Fund
Leo de Bever, Wayne Kozun and Barbara Zvan

12 Risk Budgeting with Conditional Risk Tolerance
Michael de Marco and Todd E. Petzel

13 VAR for Fund Managers
Stephen Rees

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  QUOTES

″Rahl has done an excellent job in providing a collection of articles that clearly bring together the concepts surrounding risk budgeting, which should be essential reading for anyone with an interest in this area.″
Douglas Long, Principia Partners

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  REVIEW

Risk Budgeting Tradeoffs

Hedge funds that appear to offer the best tradeoff of risk and return may actually be the worst choice for placing your money.
That's the contention of two contributing authors of the book ″Risk Budgeting: A New Approach to Investing,″ edited by Leslie Rahl, president of Capital Market Risk Advisors, New York.
In a captivating chapter called ″The Dangers of Historical Hedge Fund Data,″ Andrew B. Weisman and Jerome D. Abernathy, make a strong argument that conventional methods for evaluating asset classes can steer institutions into the worst possible alternative strategies.
Understandably, when institutions are confronted with an alternative strategy or vehicle like a hedge fund, they turn to methods they know, like optimization. ″It's the wrong thing to do,″ said Mr. Weisman in an interview. Many alternative strategies at hedge funds don't behave in a linear fashion, a prerequisite for optimization analysis.
Instead, Mr. Weisman advocates a method he developed with Mr. Abernathy to evaluate hedge fund risk called Generic Model Decomposition. GMD seeks to recreate a generic version of a hedge fund manager's investment methods, and then uses that model to estimate risk of the strategy over the long term. GMD allows managers with short track records to be evaluated for the long term. The method combines quantitative and some qualitative research.
Mr. Weisman, who is chief investment officer for Nikko Securities International Inc., New York, and Mr. Abernathy, who is managing partner of Stonebrook Structured Products LLC, New York, also said two core lessons regarding hedge fund investing were revealed when developing GMD.
For one, certain classes of hedge fund managers use methods that carry hidden short option exposure, leading investors to allocate too much to that class when using optimization techniques. Implicit short options exposures can lead to high Sharpe ratios-suggesting that the investment offers a good tradeoff of risk and return. But in reality, one of the infrequent ″volatility events″ linked to that strategy has not yet occurred, so risk is improperly measured on the downside. Once that event occurs, or by simulating the strategy using GMD, a more accurate measure of risk can be identified.
Moreover, hedge fund managers tend to understate the volatility of their portfolios by way of inaccurate pricing. It's not that hedge fund managers are trying to deceive, it's just that many of the illiquid securities and positions they hold are difficult to price properly. Risk calculations based on market values may then be understated. (Mr. Weisman recently presented a well-received paper with a related theme to the Institute for Quantitative Research in Finance, known as the Q Group.)
For hedge fund professionals, the chapter by Messrs. Weisman and Abernathy alone makes the book a worthy read. The authors essentially point out what could be a fundamental flaw in the way hedge funds manage assets for institutional investors. Ignore it at your own risk.
Value at Risk
The rest of the book, which is aimed at institutions, is more typical of financial compilations, offering explanations and discussions of the basics and a little more. Among the highlights: Ms. Rahl offers a strong synopsis of the state of Value at Risk. There are no great revelations in her opening chapter, but she provides the proper, broad perspective needed for such a book.
Michelle McCarthy, managing director for Deutsche Bank, contributes a clear-eyed guide for using Value at Risk at the customer level. Ms. McCarthy punches holes in some misconceptions about VAR-such as that VAR can only be computed for short-term holding periods-and points to the specific risks investors should be managing.
A group of authors that work in the Research and Economics department of the Ontario Teachers' Pension Plan Board, North York, show how VAR can be applied in the real world. Leo de Bever, senior vice president, Wayne Kozun, director, and Barbara Zvan, director, describe how the Ontario pension fund budgets and allocates risk among its portfolio managers. The authors deserve recognition for writing about a dry subject in an interesting fashion.
Similarly, Michael de Marco, senior vice president for Putnam Institutional Management, Boston, and Todd E. Petzel, president and chief investment officer for Commonfund Asset Management Co. Inc., Wilton, Conn., deliver a readable and practical guide for institutional investors seeking to use VAR.
The book can give VAR neophytes a glimpse into the complicated world of risk management; while more advanced practitioners can use it as a reference to call upon when structuring their own VAR programs.
By Paul Barr, Reporter
PBarr@HedgeWorld.com

Reviewed by Douglas Long, Principia Partners.

Risk budgeting, a relatively new concept for long-term investments, aims to overturn or at least supplement the traditional asset allocation techniques with a modern risk management framework. The market is already beginning to move towards this new paradigm, where asset allocation is not just based on measures like standard deviations, performance, Sharpe and information ratios but also takes into account the latest risk management practices including VaR, stress testing and risk-adjusted returns. This allows for a more informed decision-making process regarding the fund/portfolio compositions. These ideas, although not new in themselves, have not been systematically applied in this field.
The book is edited and introduced by Leslie Rahl, an influential and highly regarded risk management and derivatives professional with some 20 years experience in the industry. Her experience is evident from both the introduction and article selection.
Risk budgeting is first of all introduced in two articles, one by Leslie Rahl and the other by Myron Scholes, which provide an excellent overview and experienced views of historical and current investment risk management techniques and trends. The book then proceeds with 11 chapters that are aimed at giving the reader a greater understanding of the concepts and implementation procedures behind risk budgeting.
The collection of articles is taken from all angles within the industry and as such would be very useful for all practitioners in the market, whether they are asset managers or investors/plan sponsors. In particular, as investors become increasingly aware and sophisticated they are requiring more objective and informative data to aid and monitor their investment decisions.
In all Rahl has done an excellent job in providing a collection of articles that clearly bring together the concepts surrounding risk budgeting, which should be essential reading for anyone involved in this area.

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  AUTHOR BIOGRAPHY

Leslie Rahl is president of Capital Market Risk Advisors, Inc, a risk management consultancy firm. Prior to founding her consultancy firm in 1991, Leslie spent 19 years at Citibank, nine of which were as head of Citibank's Derivatives Group in North America.
Ms Rahl was named among the ″Top 50 Women in Finance″ by Euromoney in 1997 and was profiled in both the fifth and 10th anniversary issues of Risk magazine. She has been published numerous times.
She was a director of the International Swaps and Derivatives Association (ISDA) for 5 years and is currently a member of the Board of the International Association of Financial Engineers and the Fischer Black Memorial Foundation and a member of the Board of Advisors for the financial engineering programme at the Sloan School. Ms Rahl received her undergraduate degree in computer science from the Massachusetts Institute of Technology and her MBA from the Sloan School of Management.

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  CONTRIBUTORS

Leslie Rahl; Myron Scholes; Kurt Winkelmann; Andrew B. Weisman and Jerome Abernathy; Christopher L. Culp, Ron Mensink and Andrea M.P. Neves; Michelle McCarthy; Robert Litterman, Jacques Longerstaey, Jacob Rosengarten and Kurt Winkelmann; Amy B. Hirsch; Joseph G. Nicholas; Gabriel Bousbib; Leo de Bever, Wayne Kozun and Barbara Zvan; Michael de Marco and Todd E. Petzel; Stephen Rees
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