How many risk measures are enough?

I was teaching our Fundamentals of Performance Measurement course yesterday and came upon a metaphor to use to justify the need for multiple views on risk: John Godfrey Saxe's poem about the blind men and the elephant. You are no doubt familiar with the story, how the blind men go to the elephant, each approaching it from a different part. One thinks that it's like a wall while another thinks it's like a snake. Since none are able to see the "big picture," their observations are very limited.

Well, to me, risk is like that elephant, and if we only use one or two measures, we only see a limited amount of what lies before us. The more measures, the better perspectives.

I love Yale Endowment Fund CIO David Swensen's statement, from his book Pioneering Portfolio Management, that “Quantitative measures of risk for individual portfolios leave much to be desired." Yes, I suspect that most people would agree that they are limited and have a much to be desired. Our only choice is to employ multiple, though limited, measures. A basket that includes Sharpe ratio, M-squared, tracking error, information ratio, value at risk, liquidity risk, extreme risk analysis, and, if you really want to, standard deviation, is a good start, I believe.

My favorite risk measure

As promised last month, I thought it would be helpful to review the various risk measures. And, I may as well discuss my favorite: Tracking Error.

Tracking error is an ideal measure to assess the active risk the manager is taking. Many risk measures (e.g., standard deviation, downside deviation) don't directly take the benchmark into consideration: tracking error does. As Grinold & Kahn put it, "the client bears the benchmark risk, and the manager bears the active risk of deviating from the benchmark." Tracking error measures the active risk: the risk the manager bears.

The math is simple: standard deviation(average portfolio return - average benchmark return):

The higher the tracking error, the more the manager has deviated from the benchmark; the lower, the closer the portfolio is to the benchmark. An active manager with a very low benchmark can be accused of employing a passive approach to investing, which can be criticized when higher fees are employed; too high a benchmark can be a signal that the manger has moved too far away from the benchmark and needs to be brought back.

Goldman Sach's "Green Zone" is an example of a risk management approach that uses tracking error to monitor their managers. Their article (see below for details) received the Dietz Award as a testament to its value. Tracking error ranges (the "green zone") are established for each client and as long as the portfolio stays within the range, everything is fine. But, if it drifts into the "yellow" or "red" zones, then an adjustment is required.

Granted, tracking error does not give an indication of the potential loss or inability to meet objectives (two commonly used definitions for risk), but it's an effective tool in monitoring the risk being taken by the manager. It should be included in your arsenal of risk measures.

Litterman, Robert B., Jacques Longerstaey, Jacob D. Rosengarten, Kurt Winkelmann, & Paul R. Laubscher. "The Green Zone...Assessing the Quality of Returns." The Journal of Performance Measurement. Spring 2001.