Lesson Three: Active Risk

More correlated than you think.

June 14, 2010

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1161959_domino_tilesAmong institutional fund managers and risk practitioners there was a common assumption and belief before the financial crisis that active risks among various managers and asset classes were uncorrelated.  This belief was tested in 2008 and what most found was that the active risks weren’t as uncorrelated as most believed.

Value equity managers, growth equity managers (which over-weighted emerging markets and commodities), fixed income managers (most with biases to get yield carry from credit), real estate managers (biased to the resource-fueled GDP boom of Alberta and western Canada), hedge funds (with equity and credit beta marketed as alpha) — all were assumed to have uncorrelated active returns. When that lack of correlation was actually needed, all of the active bets suddenly became very correlated and the resulting underperformance was much larger than expected at the same time absolute returns (beta) were also sharply negative.

The lesson learned here is that risk models should assume higher correlations between different sources of active returns to get a better view of the true level of active risk being assumed. At the same time, we learned that more work is needed to get truly uncorrelated active returns.

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