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

APPLICATIONS OF RISK MODELING

In this section, we illustrate several risk model applications typically employed for portfolio management. All applications make use of the fact that the risk model translates into a common, comparable set of numbers the imbalances the portfolio may have across many different dimensions. In some of the applications—risk budgeting and portfolio rebalancing—an optimizer that uses the risk model as an input is the optimal setting to perform the exercise.

Portfolio Construction and Risk Budgeting

Portfolio managers can be divided broadly into indexers (those that measure their returns relative to a benchmark index) and absolute return managers (typically hedge fund managers). In between stand the enhanced indexers we introduced previously in the chapter. All are typically subject to a risk budget that prescribes how much risk they are allowed to take to achieve their objectives: minimize transaction costs and match the index returns for the pure indexers, maximize the net return for the enhanced indexers, or maximize absolute returns for absolute return managers. In any of these cases, the manager has to merge all her views and constraints into a final portfolio. When constructing the portfolio, how can she manage the competing views, while respecting the risk budget? How can the views be combined to minimize the risk? What trade-offs can be made? Many different techniques can be used to structure portfolios in accordance to the manager views. ...