The evolution of risk

Chief investment officer of Windham Capital Management and researcher extraordinaire, Mark Kritzman, is using his proprietary turbulence and systemic risk indicators to calculate the internal systemic risk of total institutional portfolios. He says this analysis can deliver a powerful precursor to portfolio volatility in the future.

Understanding and focusing on how risk evolves, not just when it occurs, means you can take advantage of the relationship between risk and return in different market cycles, Mark Kritzman, managing partner and chief investment officer of Windham Capital Management, says.

The independent Boston-based asset manager sees risk as a cycle, not an event, and says that innovative risk measures – turbulence and systemic risk – can measure the interaction of risk among asset classes.

According to the Windham investment risk cycle, when market turbulence is high, asset prices are volatile and can move in unison across global markets, triggering a widespread sell-off. When systemic risk is high, markets are tightly linked and fragile, which increases the risk of a major market downturn.

“We have identified a risk cycle which describes how financial turbulence and systemic risk interact with each other and how that interaction impacts asset values. Our basic view is that markets are relatively micro-efficient but macro-inefficient,” he says.

The turbulence measure has been around since 1999. Its genesis was the concern that risk parameters used to build portfolios were not stable over time.

“There are a lot of months where nothing really happens, and other months where there are very significant events. Rather than say returns are a function of the time gone by, we separate the time frames of those that are event-driven and others which are just noise, then focus on the event-driven.”

The systemic risk measure is relatively new. Both measures are also used by State Street Associates in its portfolio construction and risk management research.

According to this thinking, Krtizman says there are nine possible market states – a combination of high, low and moderate turbulence and high, low and moderate systemic risk – and has developed a very high-powered statistical process for identifying what regime the market is in, and the probability of transitioning from one to another.

In new research, his team is looking at optimal portfolios. This involves picking four portfolios to capture the nine market states.

The earlier research focused on understanding the lead/lag relationship of risk and crises. It found there is a pronounced increase in systemic risk 40 days before a crisis and turbulence continues until the crisis breaks.

“We have developed algorithms [that] we think are good at understanding the temporal relationship between them,” he says.

Kritzman uses measures of turbulence and systemic risk to forecast tail-risk, which he says does a good job of separating a low and high tail-risk states.

As well as applying the technique across the Windham portfolios, there are other applications. He recently presented an analysis to policy makers in the US and the UK showing how measuring systemic risk can infer which companies and industries are contributing to systemic risk.

Kritzman straddles the academic and professional worlds. He has won multiple prestigious awards, sits on several advisory and editorial boards, teaches a graduate course in financial engineering at MIT and is a founding partner of State Street Associates. He says this is also applicable to the portfolios of institutional investors such as pension funds.

“Using turbulence and systemic we can calculate the internal systemic risk of a fund. We look at the asset mix and apply systemic risk to that, it shows how compact that portfolio has become and this can be a very powerful precursor to portfolio volatility in the future,” he says.

Kritzman says the risk parity strategies touted in the institutional investor market “don’t make sense to me” but measuring the cycle of risk within institutional portfolios is now an area of focus.

“What makes sense is we can come up with inter-temporal risk parity,” he says. “Knowing how the portfolio is shifting, we can make moves to hold the risk constant.

“There are whole range of extensions, it’s like we’ve discovered a new set of data.”

Kritzman has applied the methodology to endowment portfolios by looking at the risk factors in “so-called” asset classes.

A number of trends come out of the analysis: most have much larger exposure to equity risk than their equity asset allocation because assets such as high-yield bonds and hedge funds have equity risk; and a number of endowments are holding cash, which he says is very expensive in terms of opportunity cost because the yields are so low.

What he suggests is that instead of holding cash, endowments invest in a factor beta through an exchange-traded fund, then measure risk by using turbulence and systemic analysis to provide downside protection.

Kritzman says the approach has been successful used in its asset management strategies.

“A lot of tactical asset allocation strategies avoided the sell-off but also the recovery. We reinvested fairly quickly,” he says. “We haven’t seen anything that is scaling risk as well as this has. No one has paid attention to this before. There are still a lot of people who don’t know the difference between systemic and systematic risk.”