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Measuring risk in 2018
- 1. 1© 2018 Windham Capital Management, LLC
1
Measuring Risk in 2018
Lucas Turton
Windham Capital Management, LLC
Managing Partner & Chief Investment Officer
Confidential. Not for redistribution.
March 2018
- 2. 2© 2018 Windham Capital Management, LLC
Agenda
i. Results from a 2007 study published by Windham Capital Management
ii. Evidence of risk regimes
iii. Within horizon risk estimation
- 3. 3© 2018 Windham Capital Management, LLC
Moderate Allocation
US Stock 35%
Foreign Stock 24%
US Bonds 33%
Real Estate (REITs) 3%
Commodities 5%
Expected Return 8.4%
Standard Deviation 10.1%
From “Asset Allocation” M. Kritzman and L. Turton, November 2007
Traditional Value at Risk (VAR) estimates this portfolio has a 1%
chance of falling 9.9% or more over a five year period
- 4. 4© 2018 Windham Capital Management, LLC
Moderate Allocation
US Stock 35%
Foreign Stock 24%
US Bonds 33%
Real Estate (REITs) 3%
Commodities 5%
Expected Return 8.4%
Standard Deviation 10.1%
From “Asset Allocation” M. Kritzman and L. Turton, November 2007
In a 2007 paper, we estimated this portfolio had a 1% chance of
losing 35.1% or more over a five year period.
- 5. 5© 2018 Windham Capital Management, LLC
Out of Sample Results
Loss
Value at risk estimated naively 9.9%
Value at risk estimated by Windham in 2007 35.1%
Realized cumulative loss during 2008 financial crisis 29.4%
Realized maximum drawdown during 2008 financial crisis 35.5%
- 6. 6© 2016 Windham Capital Management, LLC
Conditional Correlations
The only problem with diversification is that it has never been tried.
- Correlation of U.S. and non U.S. stocks when returns are
one standard deviation above their means: -17%
- Correlation of U.S. and non U.S. stocks when returns are
one standard deviation below their means: +76%
Based on returns from January 1979 through February 2008.
- 7. 7© 2018 Windham Capital Management, LLC
Equity returns tend to be non-normally distributed
Histogram of daily returns, Wilshire 5000, January 1999 – September 2015, Source: Datastream
0
0.5
1
1.5
2
2.5
3
Full Sample
Full Sample
- 8. 8© 2018 Windham Capital Management, LLC
Regime dependent return distributions are normally distributed
Histogram of daily returns, Wilshire 5000, January 1999 – September 2015, Source: Datastream
0
0.5
1
1.5
2
2.5
3
3.5
Turbulence Distribution Breakdown
High TI Low TI
- 9. 9© 2018 Windham Capital Management, LLC
The portfolio is daily rebalanced consisting of 60% broad US equities (Wilshire 5000) and 40% broad US fixed
income (Barclays US Aggregate)
* Data for 2015 through September, Source: Datastream
13.5% -1.8% -3.0% -8.8% 20.3% 9.3% 4.9% 11.2% 6.5% -21.1% 20.1% 13.4% 4.6% 11.4% 17.9% 10.2% -2.6%
0%
5%
10%
15%
20%
25%
30%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015*
Dynamic Risk and Portfolio Returns
Risk
Return
Average Risk
- 10. 10© 2016 Windham Capital Management, LLC
Understanding Turbulence
We use a proprietary turbulence measure to differentiate calm markets from turbulent markets.
Spikes in the Turbulence index coincide with well known market events
Turbulence tends to persist in the market
0
10
20
30
40
50
60
70
TurbulenceIndex
Quiet Turbulent
Global Financial Crisis
9/11
Tech Bubble
Russian Default
Gulf War
Black Monday
Stagflation
Turbulence Index 1980 - 2009
- 11. 11© 2016 Windham Capital Management, LLC
Understanding Turbulence
Turbulent periods are
characterized by
statistically unusual price
movements in the global
markets
Turbulence is superior to
VIX because it considers
all asset classes and
takes into account shifts in
correlation
Asset1
Return
Asset 2 Return
Turbulent outliers with two correlated assets
- 13. 13© 2016 Windham Capital Management, LLC
Within-Horizon Risk Measurement
Example:
We invest $100 in a portfolio with an expected return = 8% and expected risk =
12%. Our investment horizon is five years.
Question:
What is the likelihood that our portfolio is worth $85 or less?
- 14. 14© 2016 Windham Capital Management, LLC
Within-Horizon Risk Measurement
Example:
We invest $100 in a portfolio with an expected return = 8% and expected risk =
12%. Our investment horizon is five years.
Answer:
- 15. 15© 2016 Windham Capital Management, LLC
Within-Horizon Risk Measurement
Example:
We invest $100 in a portfolio with an expected return = 8% and expected risk =
12%. Our investment horizon is five years.
Answer:
Five years from today there is less than a 1 in 50 chance that the portfolio is
worth less than $85.
- 16. 16© 2016 Windham Capital Management, LLC
Within-Horizon Risk Measurement
Example:
We invest $100 in a portfolio with an expected return = 8% and expected risk =
12%. Our investment horizon is five years.
Answer:
Five years from today there is less than a 1 in 50 chance that the portfolio is
worth less than $85.
However, there is a 1 in 7 chance that the portfolio is worth $85 or less at some
point over the next five years.
- 17. 17© 2016 Windham Capital Management, LLC
Within-Horizon Risk Measurement
Example:
We invest $100 in a portfolio with an expected return = 8% and expected risk =
12%. Our investment horizon is five years.
What does this mean?
- 18. 18© 2016 Windham Capital Management, LLC
Within-Horizon Risk Measurement
Example:
We invest $100 in a portfolio with an expected return = 8% and expected risk =
12%. Our investment horizon is five years.
What does this mean?
1) Within-horizon risk is far greater than traditional end of horizon measures.
- 19. 19© 2016 Windham Capital Management, LLC
Within-Horizon Risk Measurement
Example:
We invest $100 in a portfolio with an expected return = 8% and expected risk =
12%. Our investment horizon is five years.
What does this mean?
1) Within-horizon risk is far greater than traditional end of horizon measures.
2) Time does not diversify within-horizon risk.
- 20. 20© 2016 Windham Capital Management, LLC
Capital Market Assumptions
Asset Class Return* Risk**
Global Equity 8.0% 16.4%
REITs 9.3% 25.4%
Gold 5.4% 20.6%
Hedge Funds 5.5% 8.5%
US Fixed Income 3.0% 6.5%
* Global CAPM from Windham Portfolio Advisor
** Historical Risk from 8/2005 to 12/2017
- 21. 21© 2016 Windham Capital Management, LLC
Optimal Portfolio
34.0%
9.0%
7.0%
32.0%
18.0%
Optimal Asset Allocation*
Global Equity REITs Gold Hedge Funds US Fixed Income
* Mean-Variance optimal portfolio constrained to 10% risk
- 22. 22© 2016 Windham Capital Management, LLC
Portfolio Risk – One Year, 1% VaR
Loss
Value at risk estimated naively 7.8%
Within-horizon Value at risk with turbulent risk 26.7%
- 23. 23© 2016 Windham Capital Management, LLC
Conclusions
Downside risk measures must consider asset class risk and correlation during
periods of market turbulence
The investment path matters
Including Global Financial Crisis in your model doesn’t ensure realistic loss
assumptions
Long live quant models!
- 24. 24© 2016 Windham Capital Management, LLC
Upcoming Webinars:
Windham Software Overview
Thursday, March 8th at 1PM EST
Investment Challenges in Rising Rate
Environments
Guest Speaker: Andrew Weisman
Wednesday, April 11th at 1PM EST
https://www.windhamlabs.com/webinars/
- 25. 25© 2016 Windham Capital Management, LLC
Thank you!
Questions? Contact us at info@windhamlabs.com
- 26. 26© 2016 Windham Capital Management, LLC
Disclaimer
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