The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

APPROACHES USED TO ANALYZE RISK

In what follows, we turn to the analysis of the risk of a particular portfolio, going through the different approaches typically used. Specifically, consider a portfolio manager that is benchmarked against the Barclays Capital U.S. Aggregate Index. Moreover, suppose she believes interest rates are coming down—so she wants to be long duration—and that she wants some extra yield in her portfolio—meaning investing in bonds with relatively higher spreads. Finally, let us assume that she is mandated to keep the difference between the returns of the portfolio and the benchmark at around 15 basis points, on a monthly basis. Therefore, she has to track a benchmark, but is allowed to deviate from it up to a point in order to express views that hopefully lead to superior returns. A portfolio manager with such a mandate is called an enhanced indexer. The amount of deviation allowed is called the risk budget ( 15 basis points in our example) and can be quantified using a risk model. The risk model produces an estimate of the volatility of the difference of the portfolio and benchmark returns, called tracking error volatility (TEV).³⁰³ The portfolio manager should keep the TEV at a level equal to or less than her risk budget. For illustration, we construct a portfolio with 50 securities that is consistent with the portfolio manager’s views and risk budget and analyze it throughout this chapter.

Market Structure and Exposure Contributions

The first level ...