Risk Measurement - A Multi-Dimensional Concept!

By Sharath Sury

For the past 50 years, many financial economists and professional investment managers relied upon the concept of "mean variance optimization (MVO)" to design investment portfolios. The principle was simple: maximize mean return subject to a certain variance (risk); or minimize variance subject to a certain mean return.

While the MVO technique is well-intentioned, it suffers from an incomplete definition of risk. It has long been known that asset classes can be described using various degrees of specificity, sometimes known as "moments of the distribution." For example, the first moment of the return distribution of an asset class is its mean return. The second moment is known as variance. For a normally distributed asset class with well behaved properties, a variety of analytical techniques can be applied and conclusions drawn based upon these two moments alone (mean and variance).

Unfortunately, many asset classes do not behave according to what the normal distribution would suggest. Further, asset classes that exhibit "normality" for one time period may not exhibit it during other time periods. The incorporation of alternative asset classes (e.g., hedge funds, real estate, private equity) increases the likelihood that an overall portfolio will exhibit degrees of non-normality.

As a result, it is often important to consider at least two other "higher order" moments of the return distribution. The third moment is known as "skew" or asymmetry. It reflects the degree to which an asset class may have a higher proportion of negative (or positive) returns. Some hedge fund strategies are built and marketed explicitly on this notion: while they may exhibit low levels of variance (or standard deviation), they concomitantly exhibit high levels of negative skew (or returns which are asymmetrically biased to the downside).

The fourth moment of a return distribution is referred to as "kurtosis," or more colloquially as "fat tails." Kurtosis reflects the degree to which the return distribution may be subject to extreme events. Thus, the "fat tails" refer to the graphic representation of the returns as exhibiting a higher probability of extreme results than the normal distribution would suggest. As an example, higher levels of geopolitical uncertainty can increase the kurtosis of particular asset classes.

Thus, investment managers and asset allocators who rely solely upon the popularly employed MVO techniques may be missing key risk factors that can adversely affect a portfolio and may therefore provide solutions that are incomplete with respect to skew and kurtosis.

New methods for dealing with the shortcomings of MVO include the use of other constraints in the optimization. For example, the so-called "mean-conditional value at risk (MCVaR)" is a methodology which seeks to incorporate skew and kurtosis. CVaR essentially relates to the "area of the return profile" below which an investor is "at risk."

By maximizing mean return subject to an acceptable level of CVaR, an investment manager may be better able to capture the important risks of the portfolio. Recent (and repeated) empirical research has shown that-in hedge fund portfolios alone-the MVO methodology has underestimated the amount of risk (as defined by CVaR) by as much as 50%!

In the past few years, CVaR has been joined by other risk measures, such as "Omega," to help broaden the traditional definition of risk beyond the confines of simple variance or standard deviation. In the end, more complete definitions of risk should lead to more robust portfolio optimization solutions.

Posted by SURYONLINE.NET at 3/9/2010 6:47 PM

The Following List Contains Sharath Sury's Tentative Speaking Engagements for 2010:

• Emerging Manager's Summit 2010
  

  • Sharath Sury to Moderate a Panel Discussion over the "Asset Allocation and Risk" 
    segment

  • May 12-14, 2010 at the Swissôtel Chicago in Chicago, IL

    • The Asset Allocation and Risk segment is scheduled from 9:45am - 10:45am

Diversification - A Useful Tool, Until You Need It!
By Sharath Sury 

We have all been taught about the merits of diversification in investments. It is a variation of the old adage, "Don't put all your eggs in one basket."

Indeed, professional investment managers are trained to develop portfolios according to the tenets of Modern Portfolio Theory (MPT). MPT traces its roots to the work of Harry Markowitz and his seminal writings on "Portfolio Selection." In his pioneering research, Markowitz was able to demonstrate the mathematical basis for diversification.

Essentially, Markowitz showed that selecting assets that have a positive expected return but exhibit low or (preferably) negative correlation to one another produces a combined portfolio that retains the positive expected return properties, but with lowered risk (as defined by variance).

Theoretically, this result arises due to the presence of at least two major sources of risk: nonsystematic (or unique) risk and systematic (or market) risk. While it is very difficult to eliminate market risk, it is possible to reduce the risks associated with unique investment assets. By combining investment assets that are subject to certain specific, unique risks with other investment assets that are subject to other unique risks, it may be possible to reduce the overall risk of the combined portfolio.

For the past several decades, this has been the mantra to which all investment managers adhered. Unfortunately, recent experiences in the capital markets have led both academics and professional investment practitioners to rethink portfolio construction. With the increasing interconnectedness of global markets and investment pools, we have seen that correlation structures among various investment assets are not always stable.

In fact, assets that typically exhibit low correlation with one another can dramatically change direction and begin exhibiting increased correlation during periods of market distress. The increased correlation leads to a reduction in the power of diversification and thus to increased risk in the overall portfolio. Unfortunately, this upward shift in correlation happens at exactly the time when an investor needs correlation the most: market distress.

As a result, investment managers need to be exceedingly careful in constructing portfolios that are able to withstand the dynamic nature of correlations, especially as the market experiences large disturbances. These "disturbances" are becoming much more commonplace: the Asian currency crisis of 1997, failure of the major hedge fund "Long Term Capital Management" in 1998, the burst of the "dot-com" bubble in 2000/2001, the terrorist attacks of 2001, the burst of the real estate bubble in 2007/2008, and the credit crisis of 2008/2009. In nearly every case, correlation structures among various assets increased at precisely the time when investors needed protection the most.

The best portfolio construction techniques have an appreciation for the fact that correlation structures may change during different "states of the world" or regimes. By incorporating these state-dependent correlation structures into portfolio design and optimization, investment managers can move to better protect portfolios during times of market distress.

Sharath M. Sury - Founder and Executive Director of the Sury Initiative for Financial Innovation & Risk Management (SIFIRM) at Santa Clara University, Sharath Sury devotes his time and energy to bringing together thought leaders who can address the development of real-world solutions to the current economic climate. Sharath Sury has worked with some of the brightest and most experienced experts in finance and risk management and aims to bring a greater sense of ethics and responsibility to his profession. Through his efforts, Professor Sury has established this invaluable forum for the research and discussion of new developments in the world of economics and finance and has attracted a renewed spirit of innovation to the industry. Sharath Sury also serves as an Adjunct Professor of Economics at the University of California and Adjunct Professor of Finance at DePaul University in Chicago. Sharath Sury's interest and experience in wealth management began as an Associate and later Vice President at Goldman, Sachs & Co. He later founded and worked at S4 Capital, where he earned numerous accolades for his work.

SOURCE: http://ezinearticles.com/?Diversification---A-Useful-Tool,-Until-You-Need-It!&id=3883169

Analytic Due Diligence Using an Alpha Cost Index 

Posted On: 

Founder and Chief Executive Officer of the Sury Initiative for Financial Innovation & Risk Management (SIFIRM) at Santa Clara University in California’s Silicon Valley, Sharath Sury devotes his time and energy to the development of real-world solutions to the current economic climate. Sharath Sury has worked with some of the brightest and most experienced experts in finance and risk management through SIFIRM and aims to bring a greater sense of ethics and responsibility to his profession. Through his efforts with SIFIRM, Sharath Sury has established an invaluable forum for the research and discussion of new developments in the world of economics and finance and has attracted a renewed spirit of innovation to the industry.

Issue
Effective portfolio managers recognize that not all returns are created equally.

Examination
Investment strategies can deliver returns that are the result of systematic (market or beta) exposures, nonsystematic (skill or alpha) exposures, and random variation. The relative proportions of alpha, beta, and randomness vary across strategies and even within strategies as they evolve over time. Historically, most investment products have bundled alpha and beta. However, as low-cost, investable proxies for beta grow more pervasive, it is increasingly important for portfolio managers to consider only those actively managed products that are truly delivering incremental alpha. In this article, we introduce a new measure that adjusts product fees to account for the level of alpha delivered—the Alpha Cost Index (ACI).

Conclusion
The ACI levels the playing field by penalizing products that charge active management fees but deliver the preponderance of their returns from beta exposures; thus serving as a useful ranking tool for due diligence.

Keywords: hedge funds, alpha, beta, fees, due diligence

JEL Classifications: G10, G19

Working Paper Series

Date posted: October 06, 2009 ; Last revised: November 04, 2009

Suggested Citation

Sury, Sharath M. and Sury, Manda B, Analytic Due Diligence Using an Alpha Cost Index (April 16, 2006). Available at SSRN: http://ssrn.com/abstract=1482904

Contact Information
Sharath M. Sury (Contact Author)
Santa Clara University ( email )
500 El Camino Real
Santa Clara, CA 95053
United States
HOME PAGE:
University of California ( email )
Santa Cruz, CA 95064
United States

Manda B Sury
DePaul University - Department of Finance ( email )
1 East Jackson Blvd.
Chicago, IL 60604-2287
United States

Disclosures and References Source: http://www.manyworlds.com/exploreco.aspx?coid=CO31104305960

Learn More About Sharath Sury And Read His Latest Finance Articles! 

SOURCE: http://www.manyworlds.com/exploreco.aspx?coid=CO31104305960

Mr. Sharath Sury is an Internationally Recognized Expert in Asset Allocation and Risk Management. He is currently one of the highest rated professors at Santa Clara University and is a sought-after speaker at various US and International venues.

Posted On: 

http://www.manyworlds.com/exploreco.aspx?coid=CO31104305960

Analytic Due Diligence Using an Alpha Cost Index

Sharath M. Sury
Santa Clara University; University of California

Manda B Sury
DePaul University - Department of Finance

April 16, 2006

Abstract:
Effective portfolio managers recognize that not all returns are created equally. Investment strategies can deliver returns that are the result of systematic (market or beta) exposures, nonsystematic (skill or alpha) exposures, and random variation. The relative proportions of alpha, beta, and randomness vary across strategies and even within strategies as they evolve over time. Historically, most investment products have bundled alpha and beta. However, as low-cost, investable proxies for beta grow more pervasive, it is increasingly important for portfolio managers to consider only those actively managed products that are truly delivering incremental alpha. In this article, we introduce a new measure that adjusts product fees to account for the level of alpha delivered—the Alpha Cost Index (ACI). The ACI levels the playing field by penalizing products that charge active management fees but deliver the preponderance of their returns from beta exposures; thus serving as a useful ranking tool for due diligence.

Keywords: hedge funds, alpha, beta, fees, due diligence

JEL Classifications: G10, G19

Working Paper Series
Date posted: October 06, 2009 ; Last revised: November 04, 2009
Suggested Citation
Sury, Sharath M. and Sury, Manda B, Analytic Due Diligence Using an Alpha Cost Index (April 16, 2006). Available at SSRN: http://ssrn.com/abstract=1482904

Export to: Export Citation What's this?

Contact Information
Sharath M. Sury (Contact Author)
Santa Clara University ( email )
500 El Camino Real
Santa Clara, CA 95053
United States
HOME PAGE: http://phonebook.scu.edu/index.cfm?v=pid&i=1894
/>University of California ( email )
Santa Cruz, CA 95064
United States

Manda B Sury
DePaul University - Department of Finance ( email )
1 East Jackson Blvd.
Chicago, IL 60604-2287
United States

Sharath Sury Explains The Alpha to Eager Finance Enthusiasts and Focused Students Online

 SANTA CLARA, Calif. March 6/Everything-Finance.net/ -- With many finance students and enthusiasts eager to solidify the concepts of Alpha and Beta within the context of the recent Alternative Investment Summit chaired by Mr. Sharath Sury, many followers have shown continued interest online, posting comments on various blogs that reveal an eagerly awaiting clarification of this elusive Alpha by an experienced, esteemed professional like Sharath Sury - an internationally recognized expert in Risk Management and Asset Allocation. As a former VP at Goldman Sachs, and CEO Emeritus of S4 Capital, Sharath Sury handled very complex investment portfolios of some of the nation's most wealthy families and individuals.  Mr. Sury is has been recognized by numerous notable magazines as one of the top professionals in his field.  Also a revered university instructor, Professor Sury has established a forum for the research and discussion of new developments in economics and finance, with an emphasis on risk management and innovation.  Who better to answer our audience's questions than Mr. Sury, himself?  Everything-Finance.net now has the exclusive, wealth manager's definition of Alpha by Professor Sharath Sury, in his own words:

"In any investment strategy, there are essentially three components to the ex-post return: market related exposure (beta), manager skill or 'risk adjusted excess return' (alpha), and randomness. The goal of any active investment manager is to maximize alpha to the extent possible as this is the portion of the return that is attributable to the manager's skill or strategy. In most cases, it is extremely difficult to know what alpha a manager will produce 'before the fact (ex ante)', however, there are certain clues that can help provide guidance on whether a manager is capable of delivering alpha. Among these maybe: superior execution, highly developed capital market analytic skills, superior processing of public information, ability to exploit systematic mispricings, etc. These and other such sources of alpha are colloquially referred to as 'edge'. Every successful investment manager always strives to maximize their edge, and thus their alpha."

Professor Sharath Sury has also generously extended his hand to Everything-Finance.net, offering his expertise again soon!  In the near future Sharath Sury will answer, conceptually clarify, and define additional special investment terms that have significant importance in current and future economic climates.  Special thanks to Professor Sury for taking the time to briefly analyze and precisely define these terms in efforts to help students (and enthusiasts, alike) avoid further confusion on what can already be very complicated subject material.  This is especially true -- as we've found with the Alpha -- if you're not careful about where, and in what context, you find a certain definition. 

About Sharath Sury - Founder and Executive Director of the SCU/Sury Initiative for Financial Innovation & Risk Management (SIFIRM) at Santa Clara University in California’s Silicon Valley, Sharath Sury devotes his time and energy to bringing together thought leaders who can address the development of real-world solutions to the current economic climate. Sharath Sury has worked with some of the brightest and most experienced experts in finance and risk management and aims to bring a greater sense of ethics and responsibility to his profession. Through his efforts, Professor Sury has established this invaluable forum for the research and discussion of new developments in the world of economics and finance and has attracted a renewed spirit of innovation to the industry. Sharath Sury also serves as an Adjunct Professor of Economics at the University of California and Adjunct Professor of Finance at DePaul University in Chicago. Sharath Sury's interest and experience in wealth management began as an Associate and later Vice President at Goldman, Sachs & Co. He later founded and worked at S4 Capital, where he earned numerous accolades for his work.

SOURCE: Everything-Finance.net

http://blog.everything-finance.net/2010/03/06/exclusive-sharath-sury-explains-the-alpha-to-finance-enthusiasts-worldwide-on-everythingfinancenet.aspx  

 Copyright 2010 EVERYTHING-FINANCE.net 

Posted by Everything-Finance.net at 3/6/2010 11:13 AM | Add Comment

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