Integration of Risk and Return

Integration of Risk and Return
by Chris Cockburn and Shawn Menard

Employing risk tools such as absolute, marginal and relative VaR, risk managers can evaluate portfolio risk for diversity and determine the most efficient asset allocation and manager selection based on clearly defined risk and return parameters. The following case study demonstrates that, VaR can be an important tool to achieve the plan's objectives.

The most efficient portfolio structure can be defined by using major market indexes. Exhibit 1 shows how asset allocation and risk management are inextricably linked. The policy risk summary displays major market indexes that act as benchmarks for the multi-manager fund. Benchmark VaR depicts the risk of the referenced performance benchmark; this provides a mechanism for evaluating risks and returns relative to established benchmarks. The degree of correlation between the different indexes contributes to the diversification within the portfolio. In this case, the diversification benefit is 0.72%. This can be a reiterative process in order to determine the optimal portfolio structure. For the policy portfolio, VaR establishes a risk reference that the actual portfolio should be monitored against.

Asset allocation decisions can be facilitated through the use of VaR. Exhibit 2 depicts a two-asset class portfolio structure with a policy asset allocation of 50/50 equities and fixed income. The total fund is taking on less risk than the policy portfolio. However, the return is considerably less than the policy benchmark. The absolute VaR calculation provides a mechanism to compare risk across portfolios and benchmarks. Perhaps the fund can afford to take on more risk in order to enhance expected returns. The risk manager may also wish to re-examine the impact of investment styles on the portfolio or to take advantage of tactical asset allocation.

VaR can be used to calculate the relative risk contribution of individual portfolios and managers to the total fund. The absolute VaR numbers show that North Capital Management is taking on the most risk with an 8.56% VaR, but was not able to generate the highest return.

The use of marginal VaR identifies opportunities to reduce the overall VaR of the fund by providing the risk manager with the means to quantify the risk contribution of each individual portfolio manager. By reviewing the marginal risk we can determine which managers are providing the highest diversification benefit. A low marginal VaR is considered favourable. West Intl. Fixed Income has the lower marginal risk at 27% and thus displays a substantially low negative correlation with the other managers in the fund. The risk manager can use this measure to rebalance the portfolio or optimize the asset allocation. The overall risk of the fund could be reduced by allocating more money to West International, while reducing funding to other managers who are adding higher incremental risk to the entire portfolio.

Relative VaR will highlight managers who display the lowest tracking error of returns relative to their benchmark on a risk-adjusted basis and identifies managers that have the greatest chance to under- or overperform relative to that benchmark. The relative VaR is determined by shorting the benchmark against a portfolio and calculating VaR.

Chris Cockburn is Managing Director of Russell/Mellon Analytical Services and Shawn Menard is Director of Russell/Mellon Analytical Services in Toronto. Presented at the conference by Kristen Walters.

Contex Group