Andrew Clark of Thomson Reuters looks at the role and application of risk-based indices, and discusses where and how they can be effective.

Date: Mar 2012

Tags: Indices, Risk, Hedge funds, Liquidity

• For risk-based indices, the first thing to do is pull out any correlation to try to understand the remaining risk
• Risk-based indices are suitable for hedge funds, commodity futures, for individual stocks, and for ETFs – as well as for derivatives based on all these
• So far in Asia, risk-based approaches mainly used for hedge funds, because of the effectiveness of this methodology in assembling funds of hedge funds to cater to the appetite of private clients
• Liquidity is a key consideration when constructing risk-based indices – because it is important to be able to swap out the underlying stock, commodity, hedge fund or ETF

According to Andrew Clark in an interview, most returns tend to be driven to a certain extent by general market movements.

So in a particular country, for example, a movement in the main equity index tends to be reflected in most of the stocks which are traded in the country, he explained.

For risk-based indices, the first thing to do, therefore, is pull out this correlation to try to understand the remaining risk. Whatever it is possible to say about that risk, said Clark, is what makes up the risk-based measures because the remaining risks can be reasonably well quantified. It is then possible to break this down into conservative, moderate and aggressive.

Applying risk-based indices

How to put together hedge funds, for example, into a reasonable group for investing purposes is difficult, said Clark.

However, there are ways of being able to identify hedge funds in a classification system, such as Lipper.

It is then possible to see, for example, that managed futures and global equity might be the least risky at a certain point, so by putting together these strategies into a fund of hedge funds, this can be considered to be conservative, he explained.

Similar approaches can be done for moderate and aggressive strategies, based on the relevant classifications.

In terms other asset classes, Clark said risk-based indices are also suitable for commodity futures, for individual stocks, and for ETFs – as well as for derivatives based on all these.

The methodology is fairly straightforward, he explained, so it can be used on anything which is a reasonably well-traded instrument. The issue with bonds, however, is that they are a decaying instrument.

So far in Asia, Clark said he has seen risk-based approaches mainly used for hedge funds, because of the effectiveness of this methodology in assembling funds of hedge funds to cater to the appetite of private clients.

Considerations with risk-based indices

According to Clark, liquidity is a key consideration when constructing risk-based indices. This is because it is important to be able to swap out the underlying stock, commodity, hedge fund or ETF.

This requires enough liquidity in the individual investments so that if there is a need to rotate something out, this can be done within a reasonable period of time, he explained.

Investors should really decide where they want to be on the risk curve, and then hedge this accordingly, if needed.