Strategic Risk Management: Designing Portfolios and Managing Risk

by Campbell R. Harvey, Sandy Rattray, Otto Van Hemert

STRATEGIC RISK MANAGEMENT Having just experienced a global pandemic that sent equity markets into a tailspin in March 2020, risk management is a more relevant topic than ever. It remains, however, an often poorly understood afterthought. Many portfolios are designed without any thought given to risk management before they are handed off to a dedicated—but separate—risk management team.

In Strategic Risk Designing Portfolios and Managing Risk, Campbell R. Harvey, Sandy Rattray, and Otto Van Hemert deliver a reimagining of the risk management process. The book envisions a marriage between the investment and risk processes, an approach that has proven successful at the world’s largest publicly listed hedge fund, Man Group.

The authors provide readers with a new framework for portfolio design that includes defensive strategies, drawdown risk controls, volatility targeting, and actively timing rebalancing trades. You will learn about how the book’s new approach to risk management fared during the recent market drawdown at the height of the COVID-19 pandemic. You will also discover why the traditional risk weighting approach only works on certain classes of assets.

The book shows you how to accurately evaluate the costs of defensive strategies and which ones offer the best and most cost-effective protection against market downturns. Finally, you will learn how to obtain a more balanced return stream by targeting volatility rather than a constant notional exposure and gain a deeper understanding of concepts like portfolio rebalancing.

Perfect for people working in the asset management industry and financial policy makers, Strategic Risk Designing Portfolios and Managing Risk will also earn a place in the libraries of economics and finance scholars, as well as casual readers who take an active approach to investing in their savings or pension assets.

PRAISE FOR STRATEGIC RISK MANAGEMENT

“Strategic Risk Management shows how to fully embed risk management into the portfolio management process as an equal partner to alpha. This should clearly be best practice for all asset managers.”—Jase Auby, Chief Investment Officer, the Teacher Retirement System of Texas

“This book shows the power of integrating risk and investment management, rather than applying risk management as an afterthought to satisfy set limits. I was pleased to shepherd some of the key ideas in this book through the publication process at The Journal of Portfolio Management.”—Frank J. Fabozzi, Editor, The Journal of Portfolio Management

“Financial markets today are quite different from those of the last century. Understanding leverage, correlations, tails, and other risk parameters of a portfolio is at least as important as work on signals and alpha. In that sense, bringing risk management from ‘control’ to ‘front office’ should be a priority for asset managers. This book explains how to do it.”—Marko Kolanovic, Chief Global Market Strategist, J.P. Morgan

A powerful new approach to risk management in volatile and uncertain markets

While the COVID-19 pandemic threw the importance of effective risk management into sharp relief, many investment firms hang on to a traditional and outdated model of risk management. Using siloed and independent portfolio management and risk monitoring teams, these firms miss out on the opportunities presented by integrated risk management.

Genres: Finance, Nonfiction

236 pages, Kindle Edition

Published May 20, 2021

About the author

Campbell Russell "Cam" Harvey (born June 23, 1958) is a Canadian economist, known for his work on asset allocation with changing risk and risk premiums and the problem of separating luck from skill in investment management. He is currently the J. Paul Sticht Professor of International Business at Duke University's Fuqua School of Business in Durham, North Carolina, as well as a research associate with the National Bureau of Economic Research in Cambridge, Massachusetts. He served as the 2016 president of the American Finance Association.

Reviews

[Walter Cavinaw · Rating 3 out of 5]

Some interesting insights into portfolio construction but nothing revolutionary. The authors put forth an argument that risk management should be integrated with the investment process. I recognize that it doesn't work that way for some asset managers and banks but most passionate investors would think this is obvious. Risk is arises through hidden assumptions and unfavorable outcomes embedded in investment processes and analysis. Portfolio construction needs to be holistic (combined risk+investment processes) in order to understand and mitigate risks.

They dedicated chapters to common risk management practices and dove into each with some detail.

Trend following across different asset classes: the equity exposure of trend following is similar to a long straddle. The whole book builds off this first chapter and they use trend following as an investment signal through, for example by adding it to asset allocation strategies or using it for strategic rebalancing.

Volatility targeting: it improves sharpe for equities and credit (volatility rises during stress so cutting risk during those times is similar to trend following). Doesn't work well for bonds and commodities because volatility tends to be to the upside. This chapter changed my perspective on volatility scaling. It is often used in asset allocation but now I'm skeptical that changing allocation in the short term based on volatility is a good idea. Trend seems to be a better tactical indicator. Long term vol scaling (risk parity) is different because the scaling doesn't change over short periods.

They examine the performance of a number of defensive strategies. They cover tail hedging, credit protection, quality or defensive long-short trades. L/S on quality/defensives has positive carry and performs very well during bear markets and recessions. Gold is an unreliable hedge and bonds have only been a good hedge in recent years.

Rebalancing strategies: periodic rebalancing is similar to being short vol (short straddles). periodic rebalancing can lead to deeper underperformance if there is no mean reversion in relative prices. They advocate for delaying the rebalance until the trend is in favor of the rebalance (strategic rebalancing). This is very intuitive to me. The rate of accumulation should match the investment horizon. If you are harvesting long term risk premia, then the investment is not urgent because it can go either way in the short term. If a tactical indicator (such as trend-following) turns positive then the purchase is more urgent and the rate of accumulation needs to be increased.

For me, this book is part of a project to understand different asset allocation (and portfolio construction) strategies. I am quite disappointed so far by the theory and assumptions behind some of the more recent common allocation tools. Bridgewater's risk parity and the original idea behind mean-variance have interesting theoretical foundations but the addition of tail hedging, trend-following, vol-scaling, active vol, rebalancing strategies seems ad-hoc. The asset management industry seems to add new asset allocation tools based on what has worked historically rather than advancing the theory of portfolio and risk management. This book has helped me see that the industry is stuck.

[Jung · Rating 5 out of 5]

"Strategic Risk Management: Designing Portfolios and Managing Risk" by Campbell R. Harvey, Sandy Rattray, and Otto van Hemert provides investors with scientifically backed strategies to safeguard their portfolios from unexpected market downturns and financial crises. The book explores resilient investment strategies, advanced risk management methods, and integrated approaches that outperformed traditional investments during the COVID-19 pandemic-induced crash. The concept of "crisis alpha" takes center stage, emphasizing the generation of extra returns during market turbulence. Trend-following strategies are highlighted as crucial components of crisis alpha, dynamically adjusting risk by capturing momentum across various assets such as stocks, bonds, and commodities. The book addresses concerns about the effectiveness of trend-following in the face of rising government bond yields, affirming its historical success in protecting against tail risks.

Creating a crisis-proof portfolio is presented as the investor's Holy Grail, although complete crisis-proofing may be elusive due to the inherent trade-off between security and cost. The book explores various tools and strategies, including continuously holding short-dated put options, investing in "safe haven" treasury bonds, and dynamic strategies like momentum and shorting currency carry. While acknowledging the impossibility of absolute crisis-proofing, the book advocates for the creation of a crisis-resilient portfolio that balances security and cost-effectiveness. Risk management strategies are introduced, with a focus on volatility targeting. The concept involves keeping portfolio volatility steady at a predetermined level by adjusting leverage based on changes in volatility. Volatility targeting is shown to counteract fluctuations, resulting in higher risk-adjusted returns and smaller drawdowns. The book also explores strategic rebalancing as a risk mitigation strategy, emphasizing the importance of finding a balance between regular rebalancing and incorporating considerations such as cash inflows, outflows, and exposure to stock-bond trends.

The discussion extends to drawdown strategies, acknowledging the human element in investment management. Drawdowns, quantifying potential downside risk, are explored in the context of making decisions related to investment managers. The book suggests establishing reasonable limits based on return distribution parameters, implementing preset drawdown rules, and adopting time-varying drawdown rules to address the challenges of skill deterioration over time. Two approaches to fund management, systematic and discretionary, are compared, emphasizing their complementary strengths and vulnerabilities. Systematic funds leverage algorithmic, rules-based strategies, while discretionary funds rely on human expertise. The book encourages investors to recognize the strengths of each approach and align their choices with their objectives, time horizon, and risk profile.

Finally, the book puts its quantitative strategic risk management framework to the test during the COVID-19 pandemic, demonstrating the effectiveness of the outlined strategies in real-world extremes. Trend-following, volatility targeting, and strategic rebalancing are identified as advanced methods that, when integrated with investments, substantially mitigate drawdowns even during unprecedented crises. In conclusion, "Strategic Risk Management" provides investors with a comprehensive guide to building resilient portfolios and managing risks. The book combines scientifically backed strategies, empirical evidence from stress tests, and a forward-looking approach to empower investors in navigating financial challenges and achieving long-term success in managing their investments.

[TechTim · Rating 4 out of 5]

This book is focusing on portfolio and risk management, not trading, it has some core concepts, use strategic way to reduce risk in low cost.

1. Use Beta Neutral instead of Dollar Neutral
2. Volatility Targeting
3. Strategic Rebalancing
4. Draw control

These methods can be helpful to reduce risk in lower cost, please note this book is not focusing on how to do it or how to achieve it, but on why we need to do it, or why this method is better than other, or what is the goals etc.

[Sean Daly · Rating 5 out of 5]

An indepth, technical but well written series of white papers examining and highlighting the importance of incorporating risk management practices into investment processes.

The book gives a solid overview of a number of different investment strategies. Evaluate each in turn and lays out the pros and cons.

I would highly recommend this book to anyone interested in professional investments.

[Gio Steckel · Rating 5 out of 5]

This book has a good approach to addressing multiple risk management and downside protection techniques in a consistent framework. The added bonus of writing the book prior to covid and being able to add a chapter about the out of sample success of the program add a great touch that brings the framework together nicely.