UK - Current risk models used by fund managers can be vastly different to actual levels of portfolio risk, an ABN Amro report claims.
The report follows last year’s High Court wrangle between Unilever and Merrill Lynch Investment Managers (MLIM) at which Unilever argued that risk levels followed by MLIM in its UK equity portfolio were excessively high.
The report – Laying the Foundations: Exploring the Pitfalls of Portfolio Construction and Optimisation – shows that actual levels of risk can be as much as 150% higher than forecast levels.
ABN Amro head of global quantitative analysis Stefan Hartmann said: “It is vital that the limitations of these models are understood fully. The risk forecasts supplied to fund managers can often focus too much attention on individual risk numbers, rather than providing information on the errors that these estimates are subject to.”
“Fund managers who understand the potential sources of error in risk forecasts can design their funds to incorporate this. This is particularly important, as recent events have shown that failure to keep within defined risk boundaries can lead to compensation claims.”
The report lists five factors that, when combined, can lead to actual risk levels being 150% higher than those forecast, including the effect of time varying volatilities and correlations and the effect of estimation error in volatility and correlation forecasts.
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