Strategy Risk
(Third Quarter 2007)

In a look through a fund prospectus, an investor can find dozens of risks identified and explained by the manager. As if these were not enough, more sophisticated investors run additional risk assessments during a due diligence review by analyzing the positions in a portfolio and running scenario tests or stress tests to explore worst-case outcomes. From experience however, investors know that there will be risks in a portfolio that cannot be properly defined, and a market dislocation such as occurred in July and August of this year will reveal hidden risks.

Strategy risk is one type of these hidden risks. No manager will reveal every detail of the workings of his/her strategy so investors can only probe from the outside to get an understanding. Events this summer opened a window into many strategies. The market impact spread widely across the US, Japan and Europe and across asset classes. After a long period of low volatility, there was a greater tolerance for risk coupled with a lower estimation of risk. Many “easy alpha” strategies, such as the Yen carry trade unwound creating losses and more uncertainty going forward. Also, many quant managers found themselves in the same boat, holding similar positions and similar leverage.


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