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Dice and numbers

State Street identifies new approaches to managing portfolio risks

The market volatility over the course of 2007 to 2009 has challenged long-held tenets of asset allocation, including investors’ reliance on portfolio construction and risk models centred on average market behaviour and normal return distributions, a report by State Street says.

State Street’s latest report, “Rethinking Asset Allocation”, examines the changing views of traditional practices and identifies new techniques and investment strategies that focus on measures of market turbulence, risk, liquidity and diversification. 
“The financial crisis exposed the need to understand the limitations of traditional practices such as Modern Portfolio Theory, and heightened the need for new approaches to strategic and tactical asset allocation,” says Dan Farley, global head of the multi-asset class solutions group at State Street Global Advisors. “Thanks to lessons learned from this period, many investors have gained a more nuanced reminder of portfolio risks centering on market volatility, portfolio construction and trading liquidity.”
The credit-driven nature of the financial crisis made liquidity management a critical new challenge. To better integrate liquidity considerations into asset allocation decisions, investors should enhance their allocation process with optimal rebalancing, the Vision Focus report recommends.
Non-normal investment returns and dramatic swings in valuation may occur more frequently in coming years, the report states. Consequently, investors should give new consideration to within-horizon risk, investment regimes and turbulence.
“Increasingly, investors are turning to regime-specific risk analysis to form a more complete picture of portfolio risk,” says Will Kinlaw, managing director and head of portfolio and risk management research at State Street Global Markets. “The study of turbulence, a statistical measure designed to identify periods of unusual financial returns, helps us to understand how specific market segments react during turbulent and non-turbulent times.” 
As evidence of the rethinking now underway, the Vision Focus report cites “new, emerging quantitative approaches aimed specifically at the challenges of turbulent markets and the non-normal returns they engender. The study of turbulence and unusual price movements, for example, helps investors to understand market sentiment and construct robust risk models.”

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