Building a Better Equity Risk Model

As there is virtually no limit to the number of strategies available to investors these days, crafting a universally accepted, fully scalable equity risk model is no small feat. Solutions must have a standardized feel yet be nimble enough to reflect ongoing industry changes and align with a manager’s particular investment style. At Axioma, for instance, clients can choose among fundamental and statistical medium- and short-horizon global, regional and single-country models, as well as a US macroeconomic risk model. This flexibility provides a more in-depth and accurate assessment of portfolio risk.

Fine Tuning Model Methodologies

Risk models can be fine-tuned by making improvements to the estimation universe. For instance, stock data that is missing or incomplete due to illiquid returns or insufficient performance history can easily skew portfolio analysis, resulting in factor return errors. To remedy this, we can exclude IPOs or other new issues from the estimation universe, along with any stock lacking a substantive record of returns for at least the past eight months.

But is it necessary to address every one of these illiquid "outliers"? There are certain circumstances – say, when working with frontier markets, depositary receipts (ADRs) as well as other foreign issues – where it becomes necessary to make some accommodations for illiquidity. One way to achieve this is through a proxy return component, which allows investors to generate synthetic returns for the purpose of estimating IPOs or illiquid asset performance, as well as in other situations where actual returns aren’t fully available.

Configuring models to account for other nuances is also key: for example, Axioma’s Worldwide Risk Model (WW4) sports a proprietary “returns-timing” adjustment feature that makes allowances for different global market close times. For example, if the Hong Kong trading day ends, and then the US markets decline during its trading day, then the risk model should reflect the latest market activity and adjust the risk of the Hong Kong-based securities. Our models capture this nuance, which results in a more accurate risk assessment for global portfolios that trade intraday.

Focus on Risk Factors

Regularly updating one’s list of risk factors is also paramount, particularly as newer markets and strategies continue to emerge. Axioma’s style factors include separate value and earnings yield factors to account for the interplay between the two, as well as dividend yield and profitability factors. We augmented our leverage factor to include a debt-to-equity ratio (in addition to debt to assets), for example, which allows users to consider the impact of leverage on the financial sector (in contrast to non-financial industries). Similarly, adding a profitability component for factors like gross margins, return on equity and cash flow to assets gives quality or profitability based managers a reliable metric with which to gauge ongoing fund performance and risk attribution.

Differentiation

Portfolio managers should avoid the possibility of using factors and strategies that are too similar to their peers. Axioma has solutions that help our clients create factors and models that can be customized to match their preferred investment style, which results in more intuitive performance attribution and a more accurate risk-return profile. For example, we offer a diverse Factor Library that gives clients the tools to analyze asset and portfolio sensitivities to an additional set of fundamental and macro factors, as well as a Risk Model Machine, which allows users to easily build fully customized risk models.

Coverage for All

The speed and sophistication of today’s marketplace demands risk solutions that are versatile enough to cover a wide range of fund approaches, including actively managed, long-short, index-tracking and more, while allowing managers the flexibility to align risk exposures with their specific objectives.

With the global markets constantly in flux, now more than ever it is crucial that risk models incorporate the most up-to-date research and are aligned and customized to the manager’s investment strategy. Partnering with an expert in the field can go a long way towards ensuring that these objectives are met.

Learn more about Axioma’s Equity Factor Risk Model Suite here.

Alessandro Michelini

Alessandro Michelini is responsible for Axioma’s Portfolio Solutions business globally, where he oversees the efforts of the client facing organization in the portfolio construction and analytics space. Alessandro joined Axioma in 2008 and successfully established the firm’s presence in EMEA acting as Head of Sales for the region. Prior to Axioma, Alessandro held a number of positions in ...