Practical Risk-Adjusted Performance Measurement. Carl R. Bacon

or eliminate entirely a major loss event on their watch. For the risk controller “Risk is bad”.

      Risk managers' and risk controllers' objectives are in conflict leading to a natural tension between them. To resolve this conflict, we need measures that assess the quality of return and answer the question, “Are we achieving sufficient return for the risk taken?”

RISK AVERSION

      It is helpful to assume that asset owners are risk averse, that is to say, that given portfolios with equal rates of return they will prefer the portfolio with the lowest risk.

      Asset owners will only accept additional risk if they are compensated by the prospect of higher returns.

EX POST AND EX ANTE

Risk is calculated in two fundamentally different ways: ex post and ex ante. Ex-post or historical risk is the analysis of risk after the event; it answers the question how risky the portfolio has been in the past.

      On the other hand, ex-ante risk or prospective risk is forward looking, based on a snapshot of the current securities and instruments within the portfolio and their historical relationship with each other; it is an estimate or forecast of the future risk of the portfolio. Obviously, the use of historical returns and correlations to forecast future risk is problematic, particularly for extreme, low probability events. Increasing the length of the historical track record or increasing the frequency of observations does not always result in an improvement because of the changing nature of markets and underlying securities. Older returns may be less reliable for future predictions, but on the other hand more recent observations may not include the more extreme results.

      Ex-post risk calculations and ex-ante risk forecasts are substantially different and therefore can lead to completely different results and conclusions. Differences between ex-post risk calculations and ex-ante risk forecasts provide significant additional information which should be monitored continuously.

DISPERSION

      For the most part risk managers and risk controllers use dispersion measures of return as a proxy for their perception of risk.

      There are several measures of return dispersion that will be discussed in this book and they all measure some aspect of the range of portfolio returns experienced in a particular time period. They all report on what has actually happened during the time period of interest. Even from an ex-post perspective, one can ask whether the return variability truly represents how much risk the asset manager took during the time period or whether one needs to explore the range of possible returns that might have (realistically) happened during the time period.

      This is an interesting question but one that is outside the scope of this book. Primarily this book is focused on historical portfolio return dispersion.

NOTES

      1 1 Glyn A. Holton (2004) Defining Risk. Financial Analysts Journal 60(6), 19–25.

      2 2 In truth I did not identify liquidity risk as a separate risk category at the time.

      3 3 AXA Rosenberg Settles Coding-Error Case with SEC. Morningstar Fund Times, 3 February 2011.

      4 4 Roger Lowenstein (2000) When Genius Failed: The Rise and Fall of Long-Term Capital Management. Random House.

      5 5 M. Latham (2019) The Neil Woodford Crisis: An Accident Waiting to Happen? Funds Europe, July–August.

      6 6 N. Corbishley (2019) Liquidity Crisis at Woodford Equity Fund is Symptomatic of Systemic Problem, Bank of England Warns. Wolf Street, 12 July.

      7 7 J. Booth (2019) Carney Warns that Woodford-style Funds Are “Built on a Lie”. City A.M., 26 June.

      8 8 Owen Walker (2021) Built on a Lie. Penguin Random House.

      9 9 R. Z. Wiggins, T. Piontek and A. Metrick (2014) The Lehman Brothers Bankruptcy. Yale Program on Financial Stability Case Study 2014-3A-V1.

      10 10 Asset owners are investors, typically pension funds, endowments, sovereign wealth funds, boards of investment trusts and high net wealth individuals.

      11 11 A. F. Perold and R. Alloway (2003) The Unilever Superannuation Fund vs. Merrill Lynch. Harvard Business School Publishing.

      12 12 In this book the terms portfolio manager and asset manager are to some degree interchangeable. I use the term portfolio manager in the context of individual managers employed by asset managers charged with the management of a portfolio of assets.