Mr. McCormack is Head of Quantitative Equities and Risk. Mr. Perkins is Chief Investment Officer, Equities.
In the eyes of some investors, members of a risk management team are auditors — a “necessary evil” in the process of overseeing an investment portfolio. We see it differently. In our view, the most effective risk analysts are fully integrated with investment teams. They are a welcome part of the process, and they build strong collaborative relationships with portfolio managers. We also believe these analysts make a meaningful contribution to results — not just by helping to assess risks, but as active participants in portfolio construction considerations.
Widespread support and multiple measures of risk
While collaboration with investment teams is constant, our risk team also maintains an important level of independence. Portfolio managers report to our equities CIO, but the risk analysts do not, which provides a measure of checks and balances. Also, support for the function extends across the organization. Risk management roles and responsibilities are clearly defined and regularly communicated by senior management.
Our risk managers develop methodologies for calculating risk and isolating its impact on equity portfolio performance. The team employs a number of real-time, proprietary tools in their analysis. Each method, when properly understood and properly applied, has its place in helping to understand the range of possible outcomes for a portfolio. However, just as no single piece of data defines the prospects for a business or stock, no single risk measure encapsulates “the risk model.” We believe a successful risk team is one that can analyze multiple measures of risk and work with investment teams before trades are executed to capture alpha.
A key to capturing alpha: Stock-specific risk
Within our risk budgeting process, we believe stock-specific risk deserves special attention. We seek to construct portfolios that spend the majority of their risk budgets on bottom-up stock views. We believe allocating the majority of risk to stock-specific sources provides the greatest opportunity for our portfolios to outperform in all types of markets.
Stock-specific risk reflects company-specific insights and is uncorrelated with market risk or other common factor risks such as beta, company size, or investment style. For a fundamental stock picker, stock-specific risk can be interpreted as a clean estimate of return potential, and there is a natural incentive for fundamental portfolio managers to seek more of it. In practice, however, it is difficult to increase stock-specific risk without concentrating the portfolio in a smaller number of securities, which may lead to unintended exposures. Thoughtful portfolio construction through collaboration with risk teams can help portfolio managers maintain higher levels of stock-specific risk while reducing risk from other less-efficient sources.
We believe a successful risk team is one that can analyze multiple measures of risk and work with investment teams before trades are executed to capture alpha.
Fundamental active portfolios with a higher percentage of risk coming from stock-specific sources have the potential for higher information ratios. Information ratio is the difference between the total returns of the portfolio and the returns of the benchmark, divided by tracking error. The higher the information ratio, the higher the active return of the portfolio, given the amount of risk taken. In our view, selecting individual stocks that might outperform while reducing or eliminating completely unintended market bets improves the consistency of active returns. We also believe it provides a better opportunity to succeed across up and down markets.
We believe our risk management is enhanced by the one-on-one dialogue between our risk analysts and portfolio managers. The conversations and working sessions are specifically tailored to individual portfolio strategies, and managers will often seek out risk analysts for additional information. In our view, the level and frequency of this interaction is a differentiator for our firm.
A range of tools for the unexpected
Tracking error. Analyzing tracking error for a portfolio can provide some insight into potential risks. However, on its own, this is no more useful in determining a portfolio’s sensitivity to extreme events than a price-to-book multiple in predicting a stock’s performance in a downturn. Instead, we consider numerous metrics to understand potential outcomes and determine reasonable courses of action.
Stress testing. These tests help determine how a portfolio is expected to perform if subjected to certain market, macroeconomic, or event stresses. Examples include severe declines in certain sectors, asset classes, or commodities. This provides critical information for constructing portfolios that are less vulnerable to sharp market moves.
Value at risk. Risk measurement often focuses on standard market conditions. However, for a realistic view on the range of potential outcomes, we believe it is also important to measure tail risk — the potential response by a portfolio to extreme events. Tail risk can be more challenging to estimate reliably, as by definition we have fewer tail events. In our analysis, we prefer to consider a longer history, measuring a greater number of extreme events to help estimate potential outcomes with more accuracy.
Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.
For informational purposes only. Not an investment recommendation.
This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
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