MANAGING DOWNSIDE RISK IN FINANCIAL MARKETS
Contributors
Sally Atwater is the Vice President of the Financial Planning Business Unit for CheckFree Investment Services, North Carolina, USA. Sally has over fifteen years of experience in the financial arena. She began her career in accounting and financial management, and as a result of an interest in retirement and estate planning, she accepted the position of Chief Operating Officer for Leonard Financial Planning in 1993. Sally joined M¨obius Group in April of 1995 and became Vice President in 1996. Soon after the acquisition of M¨obius by CheckFree in 1998, Sally became Vice President of the Financial Planning Business Unit. She is currently responsible for business, product, and market development in the personal financial planning market for CheckFree Investment Services. Sally holds an undergraduate degree in management sciences from Duke University and an MBA from the Duke University Fuqua School of Business.
Leslie A. Balzer, PhD (Cantab), BE(Hons), BSc (NSW), Grad Dip Appl Fin & Inv (SIA), FSIA, FIMA, FIEAust, FAICD, AFAIM, Cmath, CPEng, is Senior Portfolio Manager for State Street Global Advisors in Sydney, Australia. His experience covers industry, commerce, academia and includes periods as Investment Manager for Lend Lease Investment Management, as Principal of consulting actuaries William M. Mercer Inc. and as Dean of Engineering at the Royal Melbourne Institute of Technology. Dr Balzer holds a BE in Mechanical Engineering with First Class Honours and a BSc in Mathematics & Physics from the University of New South Wales, Australia. His PhD is from the Control and Management Systems Division of the University of Cambridge, England. He also holds a Graduate Diploma in Applied Finance and Investment from the Securities Institute of Australia. He has published widely in scientific and financial literature and was awarded the prestigious Halmstad Memorial Prize from the American Actuarial Education and Research Fund for the best research contribution to the international actuarial literature in 1982. He was the first non-American to win the Paper of the Year award from the Journal of Investing.
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Robert Clarkson – after reading mathematics at the University of Glasgow, Scotland, UK, Robert Clarkson trained as an actuary and then followed a career in investment management at Scottish Mutual Assurance, latterly as General Manager (Investment). Over the past twelve years he has carried out extensive research into the theoretical foundations of finance and investment, particularly in the areas of financial risk and stockmarket efficiency. He has presented numerous papers on finance and investment to actuarial and other audiences both in the UK and abroad, and he is currently a Visiting Professor of Actuarial Science at City University, London.
Gustavo M. de Athayde is a Senior Quantitative Manager with Banco Ita´ u S.A. at S˜ao Paulo, Brazil. He has consulting experience in econometrics and finance models for the Brazilian Government and financial market. He holds a PhD in Economics, and his present research interests are portfolio design, in static and dynamic settings, econometrics of risk management models and exotic derivatives.
Kathleen Ferguson is currently Principal of Investment Technologies. She has experience of consulting to both plan sponsors and investment consultants in matters relating to investment policy and asset management, with particular emphasis on asset allocation. Ms Ferguson has broad experience in areas relating to investment management for employee benefit plans including investment policy, strategies, and guidelines, selection and monitoring investment managers, and performance measurement and ranking. She has contributed to the Journal of Investing and Investment Consultant’s Review and is a member of the Investment Management Consultants Association and the National Association of Female Executives. She holds an MBA in Finance from New York University, New York, USA.
Hal Forsey is Professor of Mathematics emeritus from San Francisco State University, USA. He has worked with Frank Sortino and the Pension Research Institute for the last ten years. He has degrees in Business (A.A. San Francisco City College), Statistics (B.S. San Francisco State), Mathematics (PhD University of Southern California) and Operations Research (MS University of California, Berkeley), and presently lives on an island north of Seattle.
Sebastiaan de Groot currently works as an Investment Analyst for Acam Advisors LLC, a hedge funds manager in New York. Previously, he worked as an Assistant Professorand PhD student atthe University of Groningen, The Netherlands. His research includes work on behavioural finance and decision models, primarily applied to asset management.
Contributors ix
Robert van der Meer holds a degree in Quantitative Business Economics, is a Dutch CPA (registered accountant) and has a PhD in Economics from the Erasmus University Rotterdam. His business career started in 1972 with Pakhoed (international storage and transport) in The Netherlands, and from 1976 until 1989 he worked with Royal Dutch/Shell in several positions in The Netherlands and abroad. During this time, he was also Managing Director of Investments of the Royal Dutch Pension Fund. From 1989 until 1995 Robert van der Meer was with AEGON as a member of the Executive Board, responsible for Investments and Treasury. In March 1995 he joined Fortis as a member of the Executive Committee of Fortis and Member of the Board of Fortis AMEV N.V. In January 1999 he was appointed member of the Management Committee of Fortis Insurance and of the Board of Directors of Fortis Insurance, Fortis Investment Management and Fortis Bank. Robert van der Meer is also a part-time Professor of Finance at the University of Groningen, The Netherlands.
Joseph Messina is Professor of Finance and Director of the Executive Development Center (EDC) at San Francisco State University, USA. Prior to assuming his position as Director of EDC, Dr Messina was Chairman of the Finance Department at San Francisco State University. Dr Messina received his PhD in Financial Economics from the University of California at Berkeley and his Masters Degree in Stochastic Control Theory from Purdue University. Dr Messina has carried out research and consulting in the areas of the term structure of interest rates, interest rate forecasting, risk analysis, asset allocation, performance measurement, and behavioural finance. His behavioural finance research has revolved around the theme of calibrating experts and how information is exchanged between experts (money managers, staff analysts) and decision makers (pension plan sponsors, portfolio managers). His research and consulting reports have been presented and published in many proceedings and journals.
Auke Plantinga is an Associate Professor at the University of Groningen, The Netherlands. He is currently conducting research in the field of performance measurement and asset-liability management.
Neil Riddles serves as Chief Operating Officer with Hansberger Global Investors, Inc., USA, where he oversees the performance measurement, portfolio accounting, and other operational areas. He has a Master of Business Administration degree from the Hagan School of Business at Iona College, and he is a Chartered Financial Analyst (CFA) and a member of the Financial Analysts Society of South Florida, Inc.
x Contributors
Mr Riddles is a member of the AIMR Performance Presentation Standards Implementation Committee, After-TaxSubcommittee, GIPSInterpretationsSubcommittee and is an affiliate member of the Investment Performance Council. He is on the advisory board of the Journal of Performance Measurement and is a frequent speaker on performance measurement related topics.
Brian Rom is President and founder of Investment Technologies (1986) a software development firm specializing in Internet-based investment advice, asset allocation, performance measurement, and risk assessment software for institutional investors. He developed the first commercial applications of postmodem portfolio theory and downside risk in collaboration with Dr Frank Sortino, Director, Pension Research Institute. Mr Rom is Adjunct Professor of Finance, Columbia University Graduate School of Business. Over the past 23 years he has published many articles and spoken at more than 50 investment conferences on investment advice, asset allocation, behavioural finance, downside risk, performance measurement and international hedge fund and derivatives investing. He holds an MBA from Columbia University, an MBA from Cape Town University, South Africa and a MS in Computer Science and Mathematics from Cape Town University.
Editors:
Dr Stephen Satchell is a Fellow of Trinity College, a Reader in Financial Econometrics at the University of Cambridge and a Visiting Professor at Birkbeck College, City University Business School, London and at the University of Technology, Sydney. He provides consultancy for a range of city institutions in the broad area of quantitative finance. He has published papers in many journals and has a particular interest in risk.
Dr Frank Sortino founded the Pension Research Institute (PRI) in the USA in 1980 and has conducted many research projects since, the results of which have been published in leading journals of finance. For several years, he has written a quarterly analysis of mutual fund performance for Pensions & Investments Magazine. Dr Sortino recently retired from San Francisco State University as Professor of Finance to devote himself full time to his position as Director of Research at the PRI.
Preface
This book is dedicated to the many students we have taught over the years, whose thought-provoking questions led us to rethink what we had learned as graduate students. For all such questioning minds, we offer the research efforts of scholars around the world who have come to the conclusion that uncertainty can be decomposed into a risk component and a reward component; that all uncertainty is not bad. Risk has to do with those returns that cause one to not accomplish their goal, which is the downside of any investment. How to conceptualize downside risk has a strong theoretical foundation that has been evolving for the past 40 years. However, a better concept is of little value to the practitioner unless it is possible to obtain reasonable estimates of downside risk. Developing powerfulestimation procedures is the domain of applied statistics, which has also been undergoing major improvements during this time frame. Part 1 of this book deals with applications of downside risk, which is the primary concern of the knowledgeable practitioner. Part 2 examines the theory that supports the applications. You will notice some differences of opinion among the authors with respect to both theory and its application. The differences are generally due to the assumptions of the authors. Theories are a thing of beauty to their creators and their devotees. But the assumptions underlying any theory cannot perfectly fit the complexity of the real world, and applying any theory requires yet another set of assumptions to twist and bend the theory into a working model. We believe that quantitative models should not be the decision-maker, they should merely provide helpful insights to decision-makers.
APPLICATIONS
The first chapter is an overview of the research conducted at the Pension Research Institute (PRI) in San Francisco, California, USA. References are
xii Preface
made to chapters by other authors that either enlarge on the findings at PRI, or offer opposing views. The second chapter, by Robert van der Meer, deals with developing goals for large defined benefit plans at Fortis Group in The Netherlands. The next chapter, by Sally Atwater, who developed the financial planning software at Checkfree Inc., proposes a new paradigm for establishing goals for defined contribution plans, such as the burgeoning 401(k) market in the US. Sally offers new insights for financial planners and consultants to 401(k) plans. Chapter 4 by Hal Forsey explains how to use the latest developments in statistical methodology to obtain more reliable estimates of downside risk. Hal also wrote the source code for the Forsey–Sortino model on the CD enclosed with this book. Chapter 5 by Brian Rom and Kathleen Ferguson illustrates the importance of skewness in the calculation of downside risk. Brian developed the first commercial version of an asset allocation model developed at PRI in the early 1980s. Chapter 6 examines alternative risk measures that are gaining popularity. Joseph Messina, chairman of the Finance Department at San Francisco State University, evaluates the Information Ratio and Value at Risk measures in light of the concept of downside deviations. Joseph points out both the strengths and weaknesses of these alternative performance standards. The final chapter in the applications part presents the case for measuring downside risk on a relative basis. Neil Riddles was responsible for performance measurement at the venerable Templeton funds. Neil is currently Chief Operating Officer at Hansberger Global Advisors. While PRI takes the contrary view expressed in Chapter 2 by van der Meer, we think Neil presents his arguments well, and this perspective should be heard.
THEORY
The theory part begins with a chapter by Leslie Balzer, a Senior Portfolio Manager with State Street Global Advisors in Australia, and a former academic. He develops a set of properties for an ideal risk measure and then uses them to present a probing review of most of the commonly used or proposed risk measures. Les confronts the confusion of ‘uncertainty’ with ‘risk’ by developing a unified theory, which separates upside and downside utility relative to the benchmark. Benchmark relative downside risk measures emerge naturally from the theory, complemented by novel concepts such as ‘upside utility leakage’. In Chapter 9, Stephen Satchell expands the class of asset pricing models based on lower-partial moments and presents a unifying structure for these models. Stephen derives some new results on the equilibrium choice of a target return, and uncovers a representative agent in downside risk models.
Preface xiii
Next, Auke Plantinga and Sebastiaan de Groot relate prospect theory, value functions, and risk adjusted returns to utility theory. They examine the Sharpe ratio, Sortino ratio, Fouse index and upside-potential (U-P) ratio to point out similarities and dissimilarities. Our colleague in Brazil, Gustavo de Athayde, offers an algorithm in Chapter 11 to calculate downside risk. Finally, Robert Clarkson proposes what he believes to be a new theory for portfolio management. This may be the most controversial chapter in the book. While we may not share all of Robert’s views, we welcome new ideas that make us think anew about the problem of assessing the risk-return trade off in portfolio management. A tutorial for installing and running the Forsey–Sortino model is provided in the Appendix. This tutorial walks the reader through each step of the installation and demonstrates how to use the model. The CD provided with this book offers two different views of how to measure downside risk in practice. The program, written by Hal Forsey in Visual Basic, presents the view of PRI. The Excel spreadsheet by Neil Riddles presents the view of the money manager. It is our sincere hope that this book will provide you with information that will allow you to make better decisions. It will not eliminate uncertainty, but it should allow you to manage uncertainty with greater skill and professionalism.
Frank A. Sortino Stephen E. Satchell
P.S.: The woman petting the rhino is Karen Sortino, and the unaltered picture on the following page was taken on safari in Kenya.
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