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Next Generation Investment Risk Management

Next Generation Investment Risk Management . Annual Conference May 23, 2012. Jerry Miccolis CFA ® , CFP ® , FCAS, MAAA. Next Generation Investment Risk Management. Next Generation Investment Risk Management. Modernized Modern Portfolio Theory. Modernizing MPT.

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Next Generation Investment Risk Management

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  1. Next Generation InvestmentRisk Management Annual Conference May 23, 2012 Jerry Miccolis CFA®, CFP®, FCAS, MAAA

  2. Next Generation Investment Risk Management Company confidential

  3. Next Generation Investment Risk Management ModernizedModern Portfolio Theory Company confidential

  4. Modernizing MPT • More realistic asset distributions • Non-normal/fat tails • More representative investment horizons • Multi-period/compound returns/risk drag • Rules-based rebalancing • More meaningful risk measures • Shortfall risk • Conditional VaR • More useful dependency measures • Correlations  copulas Company confidential

  5. Correlation — it gets the obvious cases right ρ = +1 ρ = -1 Company confidential

  6. Correlation — does it measure what matters? Company confidential

  7. We need to move from correlations… Company confidential

  8. …to copulas Company confidential

  9. Next Generation Investment Risk Management Dynamic Asset Allocation Company confidential

  10. DAA is a more proactive way than traditional rebalancing to exploit risk • Dynamic asset allocation • Explicitly treats momentum/mean reversion • Utilizes early warning signals • Signals can be internal and external • Moving average algorithms • Valuation measures • DAA reflects the fact that MPT is only as good as its inputs • Recognizes that inputs can change dynamically • Structurally sound way to: • Test your fundamental inputs • Nimbly make adjustments as appropriate • Leading Economic Indicators • Credit spreads/money flows Company confidential

  11. Our sector rotation strategy is an example of DAA • Stable-weighting • Exit/entry signaling • Trade-offs between stability and responsiveness • Three “momentum” algorithms • Each has its own strengths/ weaknesses • Rules that determine which algorithm to use at different times • Dynamically move between responsiveness and stability based on market characteristics • Filtering • To avoid too-frequent trading • Parameters optimized based on 1990-2007 data • Tested “out of sample” with 2008-2011 data Company confidential

  12. How does this strategy compare to the S&P500 Total Return Index? Company confidential

  13. How does this strategy compare to the S&P500 Total Return Index? Company confidential

  14. How else did we test this strategy? • Rolling annual returns • Maximum drawdowns • Parameter robustness Company confidential

  15. This strategy can be continuously improved upon • Stable-return investments in lieu of cash • Tactical moves into volatility • LEIs and other external signaling • Expand beyond US large-cap equity sectors • Global/international sectors • Commodities and other alternatives Company confidential

  16. Next Generation Investment Risk Management Enlightened Tail Risk Hedging Company confidential

  17. Our three criteria for an effective buy-and-hold tail risk hedge • Sudden appreciation in severe market downturns • “Severe” denoting sudden, substantial, unexpected decline in market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn’t help) • Appreciation to a degree sufficient to meaningfully offset the decline • No “give-back” during market recovery! • Very low cost • Minimize diversion of funds from productive use • No sacrifice of upside portfolio potential! • Minimal disruption to portfolio • Maintain what works in vastly more likely markets • “Don’t throw the baby out with the bathwater!” Company confidential

  18. Our criteria helped narrow our search • Traditional direct protection (e.g., puts, collars) violate our criteria • “Black Swan” funds violate our criteria • Promising idea: Exploit volatility spikes that coincide with sudden market declines • But, long-only volatility (e.g., VIX) violates our criteria • Transitory benefit • Can’t invest in directly • VIX futures: Severe negative roll yield  very high carry cost Company confidential

  19. Does anything meet our criteria? • Dynamic hedging • Puts/put spreads/VIX futures opportunistically applied • Needs constant monitoring • Potentially high cost • Correlation plays • “Call-on-call” strategies • Not yet well developed • Long/short volatility plays • Realized volatility: daily vs. weekly • Implied volatility: medium-term vs. short-term • Spread: implied vs. realized • Combinations Company confidential

  20. Our criteria in a picture Company confidential

  21. Some combinations are promising Company confidential

  22. The combined effect can be game-changing Company confidential

  23. Next Generation Investment Risk Management Company confidential

  24. For further reading on these ideas… Company confidential

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