Chasing Your Tail Sandeep Patel Anil Suri Andrew Weisman March 28 - PowerPoint PPT Presentation

Chasing Your Tail Sandeep Patel Anil Suri Andrew Weisman March 28 2007 Presentation to the Q-Group

Structure 1. History of (Risk) World: Part I 2. Advances in Portfolio Construction Analytics • Meucci (2006): Non-Normality, Extreme Co-Movements, Estimation Error, Drawdown Related Risk Measure, Extension of Black- Litterman to Non-Normal Market Views & Non-Normal Views. • Patel, Suri, Weisman (2007) Shifting Marginal Distributions to Forward Views, Resampling Adjustment for Varying Length Histories, & Adjusting for Liquidity Using Barrier Option Model.

Structure (Con’t) 3. Data Dependence Issues • Life is Out of Sample Post Bubble Drawdowns, Peso Problems, Small Sample Bias, Inaccurate Data • Poor Asset Allocation Advice 4. Normality (You Wish!) • Evidence and Observations on Non-Normality Generally Not Normal, Lack of In-Sample and Out-of- Sample Correspondence

Structure (Con’t) 5. Sources of Significant Loss Potential: • Non-Normality of the Asset Menu • Illiquidity • Incentive Structures and Negative Convexity 6. Evidence of “Alpha Migration” • Econometric Analysis of Cycle Excess Return • Intuition for Alpha Migration

Structure (Con’t) 7. Alpha Migration & Tail Loss Potential • Simple Analytical Framework • Andy’s Laws • Periodic Efficiency & Tail Loss Potential

Preliminary Thoughts: “Prediction is Very Difficult, Especially About the Future” – Niels Bohr “Everybody’s Got a Plan Till They Get Punched in the Face” – Mike Tyson

Zeitgeist Don't bet the ranch. Get more bang for your buck. Maximize output relative to input. Nothing ventured, nothing gained. Diversify instead of striving to make a killing. Don't put all your eggs in one basket; if it drops, you're in trouble. High volatility is like putting your head in the oven and your feet in the refrigerator . • Harry Markowitz, Portfolio Selection , 1952 Journal of Finance • Wins Prize 38 years later: Nobel committee decides to diversify away idiosyncratic thought...shares prize with Merton Miller and Bill Sharpe.

The Universe Consists of: • Choices – Risky Assets: Return, Volatility, Correlation • Beneficent Organizing Principle: – Diversification • Promised Land – Efficient Frontier

The Universe Populated by: The Borg – Slavishly Conformist – Single Information Set – Rational Utility Maximizing – Portfolio Constructors

Yada + Yada + Yada = Capital Asset Pricing Model • Strong Simplifying Assumptions (Efficiency) Yields the Capital Asset Pricing Model: – The Market Portfolio sits on the Efficient Frontier – All Investors Should Hold the Same Portfolio – Geared as a Function of Risk Tolerance – Idiosyncratic (Security Specific) Risk is Diversifiable – All About: Reward vs Systematic Risk – Basis for Passive Management • Mathematics of Portfolio Theory is the Theoretical Precursor of Value-at-Risk (VaR)

The Tool Kit • Alpha • Beta • R-Squared • Correlation • Standard Deviation • Benchmarks • Tracking Error • Efficient Frontier • Scattergrams • Lots of Ratios: – Sharpe, Treynor, Jensen,Up/Down Capture, Information... • Value at Risk • Stress Testing

Positional Data • Assume it’s available • Assume it’s map-able • Assume you have sufficient infrastructure • Assume you already understand the risk well enough to design an appropriate set of stresses • Assume the portfolio will remain constant • Assume you’re King Leopold II of Belgium