Gavin Watson, the head of institutional business strategy at RiskMetrics Group visiting Australia recently from New York, believes the return of volatility is shifting the focus of global funds, and managers, from return chasing to risk management.

He says the market shake out is showing up hidden concentrations of risk that can be seen when a total portfolio approach to risk is applied. “For example financials have been so battered they may present an opportunity but if that opportunity is being taken in bonds and equities then you may be overexposed in a total portfolio sense,” he says. “The large super funds are trying to untangle all the relationships. Silos are convenient but they don’t show the relationships.” Watson says looking at trends over time is very powerful.

“You can look at say small cap managers, and what the risk contribution is to the total portfolio, and whether that is increasing or decreasing relative to a static allocation. Funds then can ask: ‘Do we change the allocation because the whole underlying market is changing out of our risk budget tolerance’?” The RiskMetrics software, which is a forward looking risk measure using the current volatility of market and current relationships has been used prevalently by the larger funds around the world.

“This is an interesting time, this return to volatility, and people who have put these tools in place, are justifying they have done the right thing. It is prudent to put it in place,” Watson says. “There is no one way to measure and manage risk and the best risk managers are moving towards stress testing rather than passive measurement.”

Watson believes the art form of risk management is stress testing, which involves testing in advance the strength of investment relationships. “It tests relationships you wouldn’t think would be broken but that may trigger events across the total portfolio,” he says. “Everyone thinks risk management is about how to reduce risk, some times it is an encouragement toward not spending the budget.”

By aggregating each position across the portfolio from the bottom up, and giving the portfolio a common language for risk, the software allows funds to have a single view of risk and reveal hidden concentrations of risk. “You need an independent way to look at, for example, whether hedge funds are all moving in the same direction. Silos are convenient but they don’t see the relationships,” he says. “Multiple exposures might be all tilting in the same way, and funds can look at an overlay technique to balance that.”