Risk Management as a source of Alpha

Pawel T. Mosakowski, September 5, 2016

It’s pretty safe to say that a robust and effective Risk Management function is not only necessary, but, in the long run, very beneficial for all involved in the investment management process. Aside from the obvious benefits of the risk control aspect, I want to examine the actual activity of managing risk.  

There is a distinction in the asset management industry between risk taking and risk management functions. Risk taking (investing) is normally associated with alpha generation, while risk management (hedging, optimization, etc.) is normally understood as a cost function. This bifurcation has rather significant implications on the business and the quality of its performance.  

But is this distinction right? Or, more precisely, can risk management be a function of alpha and revenue generation? In this piece I argue that not only can risk management be a meaningful source of alpha, but it also needs to be an integral part of the investment process.

The traditional understanding of risk management/hedging is similar to insurance: a one-way transaction in which one party pays the premium to the other party for the assumption of some risks. This construct indeed is a cost function. That said, it usually ignores the value component of risk reduction for the amount of premium. But if we apply the same principals as in the risk taking process (value and timing), then the risk management process changes as well.  As a simple example, imagine a homeowner looking to insure a house. Under normal circumstances insuring the house would involve a market driven amount of premium. However, if the house was in flames at that time, then the premium would equal the replacement value of the house, rendering the policy purchase moot. This example illustrates the value proposition and the timing component in the risk management process.

So rather than bifurcating risk taking and risk management into two distinct processes let’s put them together on the same continuum. By doing so, we combine the Portfolio Management function and the Risk Management function into one role. After all isn’t a PM supposed to be both, a skillful risk taker and an effective risk manager? The bifurcated role is akin to having a car with two drivers: one responsible for left turns and the other for the right turns. In reality, risk taking and risk reduction are two similar processes in opposite direction, and both require utilization of value and timing concepts. In this set up the forward looking dynamic of risk adjustment truly becomes a source of alpha in its own right.

This becomes very relevant to a Portfolio Manager who strives to maximize the outcome from a given opportunity set, or more precisely, to deliver the highest total return. It is not enough to concentrate on risk taking activity such as asset selection and portfolio construction. It must involve the process in which a PM can generate additional alpha managing the portfolio MTM volatility. The tweak to the investment process is that rather than concentrating mostly on finding value in the market, it becomes a dynamic continuum which starts with the asset selection/ portfolio construction but is also complemented with a dynamic risk management process which harnesses MTM volatility to deliver additional alpha. This is an independent source of alpha from the initial value framework, and in some circumstances it is the dominant source. Hence in this environment there is a clear need for an investment process which addresses these factors and incorporates dynamic alpha generating risk management.

This is particularly important in the active strategies space. An active strategy PM cannot ignore the MTM the same way passive strategies can. We have it on display today with the current struggle of the active strategies business. It starts with subpar performance and leads to relentless pressure on fees and AUM. The solution is not in the more aggressive competition on fees with the passive strategies but in improvement of the investment performance first and foremost. Why is the current performance lagging? Most traditional sources of alpha are insufficient in delivering compelling results. They have to be supplemented by a dynamic risk management activity which not only deliver extra alpha but also provide a clear and much needed differentiation from the passive strategies. I have employed the continuous multi source alpha generation investment process for a long while, and in my experience it is the best answer to the current plight of the business. I am in fact convinced that those who embrace this thought construct in their investment process will have a real competitive advantage in this environment. I’m happy to discuss further with those more seriously interested in this approach. I hope we all had a good LD weekend.