Portfolio Risk Management: Market Neutrality, Catastrophic Risk, and Fundamental Strength

Abstract

Design of investment portfolios is the most important activity in the management of mutual funds, retirement and pension funds, bank and insurance portfolio management. Such problems involve, first, choosing individual firms, industries, or industry groups that are expected to display strong performance in a competitive market, thus, leading to successful investments in the future; second, it also requires a decision analysis of how best to periodically rebalance such funds to account for evolving general and firm-specific conditions. It is the success of both these functions that allows a portfolio manager to maintain the risk-level of the fund within acceptable limits, as specified by regulatory and other policy and risk considerations. This chapter presents a methodology to deal with the above two issues encountered in the management of investment funds. While there is an abundance of literature on portfolio risk management, only a few investment managers implement disciplined, professional risk management strategies. During the stock market bubble of the late 90s, limiting risk was an afterthought, but given the increased stock market volatilities of the last decade or so, more managers are resorting to sophisticated quantitative approaches to portfolio risk management. Active risk management requires considering long-term risks due to firm fundamentals as well as short-term risks due to market correlations and dynamic evolution. The literature related to the former aspect often deals with discounted cash flow (DCF) models, while the latter topic is mainly dealt within a more quantitative and rigorous risk optimization framework. In this chapter, we propose new approaches for these longand short-term problems that are quite different from the traditional methodology. The short-term portfolio asset allocation (or weight determination) is typically optimized using a static mean-variance framework, following the early work on portfolio optimization by (Markowitz, 1952), where a quadratic programming model for trading off portfolio expected return with portfolio variance was proposed. Variants of this approach that utilize a mean absolute deviation (MAD) functional, rather than portfolio variance, have been proposed, see for instance, (Konno & Yamazaki, 1991). Asset allocation is the practice of dividing resources among different categories such as stocks, bonds, mutual funds, investment partnerships, real estate, cash equivalents and private equity. Such models are expected to lessen risk exposure since each asset class has a different correlation to the 6