downside risk while maintaining access to the upside potential is risk-controlled investing (RCI), a form of insurance. Like any other form of insurance, it comes at a certain cost. Dynamic asset allocation theory
suggests that downside risk constraints, or asset value floors, can be implemented through an optimal state-dependent weighting of the PSP component depending on the size of the risk budget. In this way, risk exposure can be adjusted in an optimal manner, allowing at the same time the highest possible exposure to the upside potential of the PSP component within the imposed risk constraints. The framework is flexible and can accommodate such floors as capital guarantees, maximum drawdowns, and rolling performance floors. The floor can also be benchmark-relative, indicating that the LHP can be adopted as a benchmark. In this way, risk-controlled investing can be done in an ALM context and provide a guarantee that the value of the assets will remain above a multiple of the value of the liabilities at any time until the horizon. As mentioned above, diversification alone is not an appropriate means of controlling downside risk. However, well diversified portfolios are a crucial ingredient in such insurance strategies because an attractive risk/ reward ratio makes it possible to lower the cost of insurance. Broadly speaking,
investment
management concerns optimal expenditure of risk budgets. To this end, diversification, hedging, and insurance represent three complementary rather than competing techniques. Diversification can be used to achieve efficient risk-adjusted returns, specific risk factors such as interest rates and inflation can be neutralized through hedging and, finally, insurance can be used to implement downside constraints. Academic research in dynamic portfolio theory suggests the three techniques can be used together to design customized investment solutions. •
By Felix Goltz, PhD, Head of Applied Research, EDHEC-Risk Institute, and Stoyan Stoyanov, PhD, Head of Research, EDHEC Risk Institute – Asia.
EDHEC Survey of the Asset and Liability Management Practices of European
Pension Funds, EDHEC-Risk Institute.
www.edhec-risk.com
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