In the current climate, a growing number of fund managers are reviewing their risk portfolios for risk associated with distressed real estate, stocks, natural resources, metals, and alternative energy. As they review these investments, many managers are finding that the relationships they now have with these products are not as tightly controlled as they used to be. For example, many instruments used in correlation analysis (the process of comparing securities that are part of a portfolio for risk and other factors) are now being used on a much broader scale to create “straddles” or “hedges” that move the portfolio into or out of the main portfolio. While historical charts and data can be used to identify relationships among securities within a fund, relying solely on this approach introduces a number of new risks. By changing how risk is managed, managers are opening themselves up to a whole new world of risks and uncertainties. To avoid this problem, fund managers are exploring the option of using sophisticated tools such as multiple regression analysis, which is able to take into account several key risk factors, including price, time, portfolio, industry, sector, and country.
While multiple regression analysis may not be able to identify every risk factor, it can significantly reduce the likelihood of identifying poor risk correlations. While past performance is one of the best predictors of future performance, past trends and cycles can also greatly impact a fund’s return. Using multiple regression to analyze historical trends and data, as well as current market data around a particular security, can help managers sift through the mountains of data to identify what they believe to be a significant relationship between one or more risk factors. This can be particularly useful for a manager who is stuck in a “what if” scenario, where he or she would like to take a quick hit on one of his or her correlated assets, but has yet to properly evaluate the impact that would have on the fund’s overall portfolio performance.
Some of the tools that are available to managers depend on the investment style that they employ, so they can be tailored to meet the needs of individual investors and portfolios. For instance, most brokerages now offer some kind of analytical tool that investors can use to track their portfolio’s returns. These tools allow managers to compare expected returns based on their investment decisions to the actual returns over time. Most allow a manager to vary the time period and frequency of updates, which makes them particularly useful when making changes to a portfolio without a drastic impact to other parts of the portfolio.
Many of these risk management tools can also help the manager to create a more proactive approach to their portfolio. Rather than waiting for news or other outside forces to affect their portfolio, the manager can take steps to mitigate that risk before it even becomes a problem. The additional risk management can help them improve their overall risk management techniques, as well as helping them avoid costly mistakes that can befall a well-managed portfolio.
Managers should also consider how much risk they are exposed to as part of their asset class analysis. If a particular investment class carries only a small portion of the total risk of the portfolio, then the manager may not need to do as much work to manage that portion of the risk. Conversely, if an asset class is very high-risk then a manager will have to do more work to manage the risks inherent in that asset class. Some asset classes, such as equity, have relatively low-risk applications but high-risk exposure, such as through market exposure. To manage both types of risk, a manager would need to be knowledgeable about the asset class and its applications.
Risk management also involves the identification and reduction of risks associated with the portfolio. There are many methods for assessing risk, including mathematical formulas and estimates by risk specialists. Managers should consider each method carefully to ensure the best fit for their portfolio. The combination of these methods may result in an underestimated risk exposure, which can be counter-productive in certain circumstances. In addition, a lack of knowledge of which method to use can result in an under-estimation of the risk that is associated with the portfolio.
A key strategy of the risk manager is to identify and eliminate unnecessary risk. For example, a stock portfolio may contain too many stocks that are not profitable. By eliminating stocks that are not likely to make money, a risk manager can improve the overall portfolio’s risk exposure and make it more responsive to changes in the marketplace. A good risk manager will be able to recommend the appropriate number of stocks to eliminate in order to lower the total risk of the portfolio. It is important for the manager to be aware of the size of the portfolio and what stocks would lik