New era for Barra risk modelling

MSCI’s risk management tool, BarraOne incorporated 31 private real estate models and a macro-factor asset allocation model in 2013 and this year will add global private equity analysis giving it coverage across all asset classes.

BarraOne, which is widely used among investors for risk analysis and management, started as an equities analysis tool, but now includes data across most asset classes.

Peter Shepard, executive director and head of multi-asset class and alternatives research at MSCI, who led the development of the new Barra Integrated Model, says the model now does two things: it covers all asset classes, and incorporates the main drivers of risk and return.

The additions reflect the many facets that drive asset classes as well as the way they interact, acknowledging that alternatives is not a single asset class, but then neither is fixed income.

In the context of factor-based asset allocation private equity has more in common with equities than say real estate.

The impact of adding alternatives is significant, Shepard says.

“By weight alternatives is about 10-15 per cent of the average portfolio, but by risk, especially active risk is it more like 90 per cent of risk.”

MSCI will work with the Burgiss Group for its private equity data and will add global private equity to the US private equity data it already incorporates in the model.

The new integrated model now also incorporates the main drivers of risk and return.

“At the highest level we have identified the main drivers of risk return. These are generalised equity (public and private), pure alternatives, and for fixed income we have credit, interest rates and break-even inflation.”

Pure alternatives are defined as the things that capture the market, such as the strategy component of hedge funds.

“There is a surprising amount of commonality among strategies, it’s the strategy beta.”

While credit is an area where credit and equity could be a single factor, the crisis showed that spreads in credit were driven by liquidity which was hard to understand in terms of underlying equity. For this reason, while they are “two sides of the same coin”, they were identified as separate factors.

One of the important facets of the factor methodology is that while it acknowledges the model needs to incorporate detail, such as that German and Greek bonds are not the same, it doesn’t need that detail on a daily basis.

“It attributes risk to macro factors and a residual factor which is like the highlight on a dashboard telling you to look beyond the hood,” Shepard says.

“There are four tiers with more factors depending on what question you are asking. The residual is there to tell you if you need to ask a question, that is a new feature added to BarraOne. “

It is used in two settings, the standard risk setting and the context of risk-factor based asset allocation, he says.

MSCI recently acquired IPD, with data across real estate and infrastructure and farmland and timberland.

“This has been a great benefit to us. In real estate the three golden words are location location, location. For us the three rules of success are data, data data.”

It has also changed the methodology as it applies to private assets, so that they are “de-smoothed”, to account for the subjectivity of private asset valuations being based on a model rather than a market transaction.

“The key is that in the long run valuations and value have to come together,” he says. “There is much higher standalone and correlation risk and this has implications for asset allocation. Private real estate being uncorrelated with other markets is not reflected in the data once you account for smoothing.”