All about risk

November 29, 2015 11:00 AM

If the portfolio construction process is simplified into these three stages, stage one is the model conviction, while stages two and three represent risk management. Once stage one is separated from risk management and held constant, risk management decisions can be isolated to create risk management-based factors. This paper will examine four factors that focus on liquidity, correlation, volatility and capacity. 

CTA risk management

Similar to the Fama French (1993) three-factor model, a multi-factor model for returns can be defined by determining a baseline strategy and corresponding style factors. The strategy used here is a trend-following strategy that allocates equal dollar risk to all included markets (82 markets are used, including equity indices, currencies, commodities and fixed income). The baseline strategy is diversified across different time horizons based on simple moving average momentum signals. The baseline strategy is simulated with $5 billion in capital traded with a 4% monthly risk target.

Consistent with actual traded portfolios, limits on positions/orders based on liquidity, risk and exchange requirements are imposed on all portfolios. These limits cut position sizes and risk must be re-allocated to hit monthly risk allocation targets. Once the baseline strategy is determined, risk management factors can be constructed by adjusting one particular aspect of risk management. The corresponding risk management factors are described in “Four keys to risk management,” (below). 

The liquidity factor measures the effect of allocating relatively more risk to highly liquid markets. Liquidity is defined by the volume and volatility for each market. From the equation for the baseline trend-following strategy, equal dollar risk means that each market gets equal risk allocation. For the liquidity factor, the risk allocation across markets will tilt more risk toward the more liquid markets. When the liquidity factor returns are positive, this means that a portfolio that allocates more risk to more liquid markets outperforms the equal dollar risk portfolio.

The correlation factor measures the effect of incorporating correlation into risk allocation. The allocation is determined by ranking markets based on their “correlation contribution” for each market. When a market is highly correlated with other markets, less risk will be allocated to it. When the correlation factor returns are positive, this means that a portfolio that incorporates correlation in risk allocation outperforms the equal dollar risk portfolio. The baseline strategy (equal dollar risk) does not consider correlation when it allocates risk across markets. 

The volatility factor measures the effect of reacting more slowly to changes in market volatility through the “volatility of market” in equation. The baseline strategy measures market volatility using a three-month lookback. The volatility factor represents the difference between the baseline and an alternate specification that measures volatility with a longer (six-month) lookback. A positive return for this factor means that during that time, the portfolio with the slower volatility adjustment outperforms the baseline. 

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About the Author

Kathryn M. Kaminski holds a PhD from the MIT Sloan School of Management as well as visiting lecturer positions at the Stockholm School of Economics and MIT Sloan School of Management. Her research interests are in portfolio management, behavioral finance and alternative investments. She is an investment researcher at RPM Risk & Portfolio Management. Contact her at