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Preface

“Beauty is in the eye of the beholder.”

Margaret Wolfe Hungerford (1855–1897), Molly Bawn 1878

There are many books and articles, perhaps hundreds, written on the subject of portfolio risk, but for the most part they focus on ex-ante risk, tend to be highly academic with authors seemingly in a competition to present the material in as complex a language as possible, prone to mathiness¹ and are typically devoid of worked examples. The first edition of this book attempted to fill the gap between practice and theory, written for risk and performance measurement practitioners from a buy side, asset management perspective, focusing on quantitative ex-post measures rather than the qualitative aspects of risk. The first edition provided the material I would have wanted to read, so why a second edition? Well, I've received many useful comments, suggestions and yes, accepted a few corrections or met the need for further clarification. I thank everyone who has contributed, even the innocent question in a training session causing my mind to wander, eventually generating that spark that leads to an epiphany. I've taken the opportunity to add a few new measures, provide additional explanations where the original clearly was not sufficient, corrected a few annoying errors and added six entirely new chapters.

Risk has an undeserved reputation within asset management for being an overly complex, mathematical subject. The purpose of this edition is to simplify the subject and demonstrate with many practical examples that risk is perfectly straightforward and not as complicated as it might seem.

In addition, I wanted to document, with appropriate referencing, as many discrete ex-post risk measures as possible in a structured format, filling gaps, encouraging consistency, suggesting new measures and highlighting possible areas of confusion or misrepresentation. In truth many of these measures are rarely used in practice, often for good reason.

This book will not recommend any particular risk measure, although it is difficult to disguise my preferences and prejudices. Risk, like beauty, is very much in the eye of the beholder and different risk measures will suit different investment strategies or asset owner concerns at different times. This book should provide enough information and insight for the reader to determine their own preferences.

In terms of structure Chapter 1 is naturally an introduction to the subject of risk in the context of asset management firms. In Chapter 2 the foundations are laid introducing the descriptive statistics that will be used in later chapters. The following chapters are structured according to the type of risk measure being considered: simple performance appraisal measures in Chapter 3; regression measures in Chapter 4; drawdown in Chapter 5; partial moments in Chapter 6; a new Chapter 7 based on prospect theory; extreme risk in Chapter 8; risk measures for fixed income instruments in Chapter 9; a new Chapter 10 including miscellaneous risk measures that are difficult to characterise; and risk-adjusted returns in Chapter 11.

Chapters 12–16 are entirely new chapters for this edition. Chapter 12 was really inspired by the background research and writing of the first edition. I wanted to classify all the ex-post risk measures and describe how they are linked; my thoughts came together too late to include the best presentation of this linkage in the first edition, which is, of course, a periodic table of risk measures. Chapter 13 discusses the use of risk-adjusted performance measures in the context of performance fees. Chapter 14 discusses dashboard design in the context of risk measures, Chapter 15 looks at the important subject of how appraisal measures should be used in the context of manager selection and Chapter 16 introduces the four dimensions of performance and makes the call for ex-ante risk standards.

In the penultimate Chapter 17 there is a discussion about which risk measures to use and finally Chapter 18 reviews their application in terms of risk control.

The objective of this edition remains to provide a complete list of ex-post risk measures used by asset managers. Although some have little merit, I've avoided censoring measures I dislike. If a risk measure is not included, maybe I don't fully understand it with enough confidence to write about it, or in a few rare cases I've determined that it literally has no merit.

Note

1 1 The misuse of mathematics in order to mislead; see Paul Romer (2015) Mathiness in the Theory of Economic Growth. American Economic Review 105, 89–93.