Managing Downside Risk Research Articles

Are VaR models effective in capturing downside risk in alternative investment funds? Insights from a cross-country study

In this paper, we analyze the downside risk of alternative investment funds (AIFs) in a cross-country setting over a period of 2015–2021, using popular Value-at-Risk (VaR henceforth) models, and test the efficacy of such models in capturing the volatility posed by these funds. We estimate VaR in the presence of three error distributions, including normal distribution, Student’s t distribution, and GED distribution. Using weekly return data of 991 AIFs from 28 countries, over the period 2015–2021, we find that most of the funds, irrespective of country representation, exhibited a significant proportion of their weekly returns to be negative. To statistically validate our findings we use three backtesting approaches, i.e., Jorion’s failure rate, Kupiec’s proportion of failure (POF) tests and Christoffersen’s independence test. Our findings indicate the presence of significant downside risk for AIFs, which these popular VaR models are unable to capture. These findings highlight the need for investors and fund managers to be cautious when relying solely on popular VaR models to manage downside risk in AIF and suggest that further research is needed to develop more effective risk management strategies for AIF, particularly in light of their complex structure and asymmetric return distributions.

Managing downside risk of low-risk anomaly portfolios

In this paper, we present a novel risk-scaling strategy based on a measure of downside risk and investigate its performance on underlying portfolios that are formed on low-risk anomaly. The downside risk-scaling strategy addresses two challenges of the volatility-scaling strategy, namely, underestimation of and indirect management of downside risk. We demonstrate that our downside risk-scaled strategy improves the unscaled underlying low-risk anomaly strategy as well as outperforms volatility-scaled strategy in terms of risk-adjusted return and various performance metrics that are related to downside events.

Failing Fast and Asymmetric Peformance Outcomes for Venture Capital Investors and Entrepreneurs

When entering exchange relationships, actors decide between vetting and developing working routines with new partners versus choosing imperfect, but familiar partners. Actors engage with those that are more familiar, for example, along ethnicity, gender, or embeddedness within a social network, in order to achieve improved coordination and reduced monitoring costs, which can result in better performance of their exchanges. For venture capitalists, decisions based on familiarity criteria manage downside risk, which leads to improved survival. This leads to more successful investments over a long time horizon but reflects worse financial outcomes for any particular venture. As a result of persistent relationships with investors, entrepreneurs may learn how to “fail fast,” but not how to learn from failure.

Assessing Mutual Fund Performance in China

Chinese fund manager performance is interesting because, in a market dominated by speculative retail trading, we expect professional fund managers to have a persistent edge. Using data on the Chinese mutual fund industry, the authors compute a new skill measure to identify exceptional funds with persistent performance. When an equity mutual fund is in the top 1% of their ranking in a particular 6-month period, the probability the fund will be among the top 10% in return in the following period is 22%. By comparison, for funds that rank in the top 1% by past 6-month return, the probability of being a top 10% fund in the next 6 months is only modestly better than noise at 12%. The authors also find declining skill and performance persistence at the industry level, likely driven by the exodus of mutual fund managers to hedge funds. They provide evidence that most of the outperforming funds in China deliver excess performance, relative to peers, through market timing. Funds that reliably pick winning stocks often do not have evidence of performance. This may be related to a mutual fund management culture that emphasizes market timing for managing downside risk over a focus on relative performance. TOPICS:Mutual fund performance, emerging markets, manager selection Key Findings • The authors develop a new mutual fund skill measure that identifies exceptional funds with persistent performance and assesses stock selection and market timing ability. They then apply this measure to Chinese mutual funds. • They demonstrate that some Chinese mutual funds exhibit persistent skill but that industry-wide skill is declining over time—likely because of a migration of the most talented managers from mutual funds to hedge funds. • The authors show that most exceptional Chinese mutual funds deliver excess performance relative to peers through market timing as opposed to stock selection, a finding consistent with management culture emphasizing downside risk management over relative returns.

Assessing Mutual Fund Performance in China

Chinese fund manager performance is interesting because in a market dominated by speculative retail trading, we expect professional fund managers to have persistent edge. Using data on the Chinese mutual fund industry, the authors compute a new skill measure to identify exceptional funds with persistent performance. When an equity mutual fund is in the top 1% of their ranking in a particular 6-month period, the probability the fund will be among the top 10% in return in the following period is 22%. By comparison for funds which rank in the top 1% by past 6-month return, the probability of being a top 10% fund in the next 6 months is only modestly better than noise at 12%. The authors also find declining skill and performance persistence at the industry level, likely driven by the exodus of mutual fund managers to hedge funds. They provide evidence that most of the outperforming funds in China deliver excess performance, relative to peers, through market timing. Funds which reliably pick winning stocks often do not evidence performance. This may be related to a mutual fund management culture which emphasizes market timing for managing downside risk over a focus on relative performance.

Downside Risk Timing by Mutual Funds

We study whether mutual funds systematically manage downside risk of their portfolios in ways that improve their performance. We find that actively managed mutual funds on average possess positive downside risk timing ability. Funds investing in large-cap and value stocks have stronger downside risk timing skills. Managers adjust funds’ downside risk exposure in response to macroeconomic information. Funds more skilled in timing downside risk outperform those which are not by 13.8bp per month (or 1.67 percent per year). JEL classification: G10, G11.

LDI: Low Yields, Customization, and Managing Downside Risk—Avoiding a “Mexican Standoff”

Liability-driven investing (LDI) has come a long way since its inception and early days as a risk management framework. The landscape now includes a broad range of providers and corresponding strategies, with varying degrees of sophistication and associated benefits. However, it faces a number of challenges as a consequence of the prevailing low-yield and low-return investment environment. This article seeks to highlight the low-yield environment and how it may be managed under a framework that creates value for investors and is aligned with those investors’ underlying fiduciary obligations. By intention, the article is broad in coverage, as a function of the many issues and considerations affecting U.S. defined-benefit pension plans as they relate to LDI and associated risk management considerations.

What Is the Nature of Hedge Fund Manager Skills? Evidence from the Risk-Arbitrage Strategy

AbstractTo understand the nature of hedge fund managers’ skills, we study the implementation of risk arbitrage by hedge funds using their portfolio holdings and comparing them with those of other institutional arbitrageurs. We find that hedge funds significantly outperform a naive risk-arbitrage portfolio by 3.7% annually on a risk-adjusted basis, whereas non–hedge fund arbitrageurs fail to outperform the benchmark. Our analysis reveals that hedge funds’ superior performance does not reflect fund managers’ ability to predict or affect the outcome of merger and acquisition deals; rather, hedge fund managers’ superior performance is attributed to their ability to manage downside risk.

Power-Log Portfolio Optimization for Managing Downside Risk

Power-Log Portfolio Optimization for Managing Downside Risk

Downside Risk Timing by Mutual Funds

We study whether mutual funds systematically manage downside risk of their portfolios in ways that improve their performance. We find that actively managed mutual funds on average possess positive downside risk timing ability. Funds investing in large-cap and value stocks have stronger downside risk timing skills. Managers adjust funds’ downside risk exposure in response to macroeconomic information. The economic value of downside risk timing is comparable to that of market timing.

Downside Risk Timing by Mutual Funds

We study whether mutual funds systematically manage downside risk of their portfolios in ways that improve their performance. We find that actively managed mutual funds on average possess positive downside risk timing ability. Funds investing in large-cap and value stocks have stronger downside risk timing skills. Managers adjust funds’ downside risk exposure in response to macroeconomic information. Funds more skilled in timing downside risk outperform those which are not by 13.8bp per month (or 1.67% annualized) unconditionally and by 48.7 bp per month (or 6.00% annualized) during recessions, and attract larger flows. For the fund with average AUM and fees, extra flows from high downside risk timing skills result in 160 thousand dollars of additional fee revenue per year.

Practical Applications of The Blind Side: Managing Downside Risk in Corporate Defined-Benefit Plans

Average funding ratios for U.S. defined-benefit pension plans are low enough to set off triggers for mandatory contribution increases and have led to a greater emphasis on risk-reduction strategies among US plan sponsors. Authors <b>Abdullah Z. Sheikh</b>, and his colleague, <b>Jianxiong Sun</b>, both of <b>J.P. Morgan Asset Management</b>, offer pension fund managers and trustees a “common sense solution” rather than a “magical formula,” in their article for the Spring 2013 issue of <b><i>The Journal of Portfolio Management</i></b>, The Blind Side: Managing Downside Risk in Corporate Defined Benefit Plans. This <b><i>Practical Applications</i></b> report explores two main facets of the authors’ approach: The impact of non-normality of asset returns on a defined-benefit pension plan’s liabilities and the development of a multidimensional risk management framework for managing contribution risk. “There are a lot of plans that are at the forefront of adopting some of the more well-thought-out solutions. At a basic level, the strategy we’re recommending is very intuitive,” says co-author Sheikh. <b>TOPICS:</b>Pension funds, financial crises and financial market history, VAR and use of alternative risk measures of trading risk

The Blind Side: Managing Downside Riskin Corporate Defined-Benefit Plans

Following the recession of the early 2000s, defined benefit corporate pension plans faced dramatic funding challenges. They had barely recovered before the recession of 2008 to 2009 sent funding ratios tumbling once again. Many plan sponsors must now make larger contributions than they originally budgeted, in order to bring their plans back to full funding. This article aims to deepen the current discussion of risk reduction in the context of defined benefit plans. It investigates two key issues. First, its authors analyze the effect of non-normality of asset returns on a defined benefit pension plan’s liabilities. They argue that analytical frameworks that assume normality can lead to an underestimation of downside risk, a concern with regard to contributions. Second, the authors develop a multi-dimensional risk-management framework for managing contribution risk. <b>TOPICS:</b>Pension funds, financial crises and financial market history, VAR and use of alternative risk measures of trading risk

Global Diversification and Downside Risk Control Through Stock, Bond, and CDS Indices

This paper analyzes the performance of index-based portfolios across developed, emerging, and frontier markets. Besides considering stocks and bonds for portfolio construction, we investigate how investment opportunity sets are enlarged when credit default swaps (CDSs) are added into portfolios as an asset class. This is different from using CDS as a hedging instrument for transferring credit risk between two parties of debt instruments. In addition, the paper investigates how to effectively manage downside risk using conditional value-at-risk (CVaR) when the aforementioned three asset classes are considered. We find that index-based portfolios of stocks, bonds, and CDSs across markets can significantly enlarge investors’ investment opportunity sets and reduce the downside risk of diversified portfolios.

The Blind Side:Managing Downside Risk in Corporate Defined Benefit Plans

The Blind Side:<i>Managing Downside Risk in Corporate Defined Benefit Plans</i>

Enhancing Value in IT Services Offshoring: Real Options Matter

Abstract In a complex global business environment, more organizations are relying on offshoring to provide critical information technology services (ITS). While there can be substantial cost savings for the offshoring firm, the decision to offshore ITS involves a considerable degree of uncertainty and it is essential to understand the issues and hurdles that will be faced by the offshoring operation. Based on a sample of 189 firms from 34 industries (with most coming from the Asia-Pacific region) that have made at least one offshoring decision, we find that larger market capitalized firms are more likely to outsource offshore than smaller firms. Our results also indicate an initial decrease in downside risk with a diminution in the decline, as offshore intensity increases. We also find some evidence of offshoring’s contribution to growth premia. In considering contingencies to adopt in order to manage downside risk, a real-options framework is discussed. Our findings support the view of offshoring as a dynamic process firms use to create value by leveraging growth options and mitigating risk. By considering the real-options possibilities, the investor gets a better picture of the potential losses and gains which should lead to more prudent IT offshoring investment decisions.

Risk-Opportunity Transforming Effect of Dollar Cost Averaging: A Study on DCA Efficiency in Managing Downside Risk

Risk-Opportunity Transforming Effect of Dollar Cost Averaging: A Study on DCA Efficiency in Managing Downside Risk

Dynamics of Entrepreneurship Under Incomplete Markets

An entrepreneur faces signicant non-diversiable business risk and liquidity constraints, two frictions that lead to incomplete markets. We provide an integrated framework to study how these frictions inuence a potential entrepreneur’s business startup/entry, capital accumulation/asset sales, portfolio allocation, consumption/saving, and business exit decisions. With frictions, entrepreneurs invest substantially less in the business, consume less, and allocate less to the market portfolio. While the business liquidation option is completely out of the money under complete markets, with frictions, this endogenous exit option provides signicant exibility and is quite valuable for the entrepreneur to manage downside risk under incomplete markets. We further derive novel empirical predictions about the economic dynamics of entrepreneurship. When liquidation is suciently distant, business investment increases with nancial wealth. However, when liquidation is suciently likely, the entrepreneur’s risk management considerations induce investment to decrease with nancial wealth, generating non-monotonicity of investment in nancial wealth. Furthermore, we show that the exibility to accumulate wealth before entering entrepreneurship is highly valuable. The optimal entry decision critically depends on the outside option, the start-up cost, risk aversion, and wealth. Heterogeneity among entrepreneurs is thus important. Finally, we provide an operational framework to calculate the private equity idiosyncratic risk premium for an entrepreneurial rm and show that this premium critically depends on wealth, non-diversiable risk, and risk aversion.

Managing Downside Risk With Upside Volatility: Enhancing The Performance Of An Investment Portfolio With Managed Futures

&lt;p class="MsoNormal" style="text-align: justify; margin: 0in 27pt 0pt 0.5in;"&gt;&lt;span style="font-size: 10pt; mso-bidi-font-weight: bold;" lang="EN-GB"&gt;&lt;span style="font-family: Times New Roman;"&gt;Managed futures refer to the active trading of forward and futures contracts on physical commodities, financial assets, and currencies.&lt;span style="mso-spacerun: yes;"&gt;&amp;nbsp; &lt;/span&gt;Since managed futures have little to no correlation with stocks and bonds, advocates claim this asset class provides much-needed diversification, allowing investors to profit from price volatility. &lt;span style="mso-spacerun: yes;"&gt;&amp;nbsp;&lt;/span&gt;However, naysayers believe this volatility makes managed futures a highly risky investment. Do the unique features of this asset class make it worthy of inclusion in an investment portfolio?&lt;span style="mso-spacerun: yes;"&gt;&amp;nbsp; &lt;/span&gt;This article asserts managed futures provide investment managers a powerful tool to manage downside risk by capitalising on upside price volatility.&lt;/span&gt;&lt;/span&gt;&lt;/p&gt;

Estimation of VaR in conditional heteroscedastic models for principal‐protected notes

PurposeThe aim of this paper is to examine the accuracy of GARCH and provide a comparison of GARCH‐type and the other time series models in financial commodity markets.Design/methodology/approachFirst, a model fitting is performed to choose suitable models with conditional volatility for principal‐protected and path‐dependent notes by means of Akaike information criterion (AIC) and Schwartz Bayesian information criterion (SBC). Second, this paper adopts the backtesting criteria and the Diebold and Mariano test to compare the performances of the selected time series models.FindingsThe empirical results show that the performance of GARCH is significantly worse than EGARCH(1,1) based on the Diebold and Mariano test criteria. By backtesting test criteria, the null hypothesis that a given confidence level is the true probability in ARCH(4) cannot be rejected. The interesting results are different from past studies.Originality/valueThere is little literature of principal‐protected notes that focuses on the downside risk for investors. But, managing downside risk is important for individual and institution investors. This paper offer new insight into the literature of principal‐protected notes.