State Street Global Markets has developed a series of “turbulence” indexes to measure volatility and the unusualness of returns.  Will Kinlaw, managing director of portfolio and risk management group at State Street Global Markets in Cambridge, said the indexes were risk management tools that can be used by funds managers in all asset classes and by pension funds at the total portfolio level for stress testing. He said turbulence was a statistical measure of unusualness – the extreme relative to investors’ expectations – or the correlation of the unusual.

The turbulence indexes were the culmination of a 10-year research effort led by research director at State Street Associates, Mark Kritzman. Kritzman, who also teaches financial engineering at MIT and is chief executive of funds manager and technology vendor Windham Capital Management, published a paper in 1999 entitled Optimal portfolios in good times and bad, which looked at the resilience of static portfolios to turbulence. This research has more recently applied to dynamic asset allocation. In quant terms, Kinlaw said it looked at multivariate z-scores, capturing extreme moves and unusual correlations. Measuring unusualness – or those patterns of interaction that are closer to expected behaviour and those that are highly unlikely – as a dynamic asset allocation input showed a relationship between turbulence and performance, he said. “Turbulence in itself is non-directional, it is extreme or unusual, but we have found a link between turbulence and performance.

We found that risky trades outperform over the long-term, but they really blow up during turbulent times.”  The research also found that turbulence was persistent. “In financial markets turbulence may arise randomly, but once it arrives it sticks around. So even if you can’t predict when it arrives, if you react quickly you can reduce risk. Our evidence suggests it is possible to improve performance by adjusting risk exposure in response to the arrival of turbulence.” The Chicago Board Options Exchange Volatility Index (VIX), which shows the market’s expectation of 30-day volatility, is a commonly used risk filter and is often referred to as the ‘investor fear gauge’.

While Kinlaw said the State Street turbulence indexes do not replace the VIX, he said the volatility yardstick had some limitations.  “If you have to pick one golf club, or index, then the VIX is good. But with the turbulence index, it is like having a whole bag of clubs because you can adapt it to any asset class.”  The VIX also only applies to equity volatility and at certain times, that is not useful for managers of other assets, such as currency specialists during the dotcom bubble. State Street built eight turbulence indexes: global asset classes, US equities, European equities; currencies, US fixed income, US Treasuries, credit and global sovereign debt. The research unit had also researched systematic risk in the past 10 months, with a view to launching a specialist index in late 2010, after this issue of Investment Magazine went to press.

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