In-Depth PictetAM-FI Risk Managment

7/25/2019 In-Depth PictetAM-FI Risk Managment

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Pictet Asset Management

September 2014

For professional investors only

Risk management Making the dierence infxed income investing


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Tough times lie ahead for fixed income investors.

The ballooning of public debt across the developed world and theimplementation of ultra-loose monetary policy in the US, Japan andEurope have forced market participants to abandon conventionalideas about risk and return.

Complicating matters further is a weakening of market

infrastructure. Tighter oversight of the banking industry has seenmany large investment banks cut back on fixed income trading,causing a reduction in the number of market makers and a

deterioration of trading conditions in the secondary market.

That all this is occurring at a time when the primary bond market

is witnessing unprecedented growth is a worrying prospect as itsuggests that the asset class may become more vulnerable to bouts ofvolatility.

Bond investing is arguably more risky than it has ever been.

It is against this backdrop that the analysis, control and mitigation ofrisk are taking on a more prominent role in the management of fixedincome investments.

To achieve long-term investment success at a time when the fixedincome market is undergoing significant upheaval, a deeperunderstanding of how risk manifests itself at the security andportfolio level is critical.

Overview

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4 Pictet Asset Management

The teams approach to managing risk

is guided by three main principles:

- Portfolios must be managed

according to specific tracking error

(TE)/ Volatility and/or Value-at-Risk

targets

- Risk targets are set according to a

clients own tolerance for risk- Diversification of risk is a key

objective for portfolio managers

The team is responsible for evaluating

and managing the risks associated

with each investment decision,

eliminating unintended risks from

portfolios and ensuring investment

professionals have a clear and holistic

view of their portfolios risk profile. It

also seeks to ensure that portfolios

risk profiles are in keeping with both

investment managers philosophy and

the strategys long-term return

objectives.

Over several years, the team has

developed a set of customisable

analytical tools that have been

adapted to meet the constantly

changing needs of our investment

managers and clients.

For all these reasons, our fixed income

risk professionals play a major role in

the construction of our bond

portfolios.

Fixed incomerisk managementat Pictet AssetManagement atthe heart of theinvestment process

Risk management has always been

central to the fixed income investment

process at Pictet Asset Management.

Our Fixed Income Risk (FI Risk)

management professionals are

members of a standalone unit that is

part of the fixed income investment

team; it reports directly to the GlobalHead of Fixed Income.

Each fixed income risk manager is a

specialist within a specific fixed

income asset class and works closely

with portfolio management teams.

By structuring the team in this way,

risk managers develop a deeper

understanding of the investment

processes of the strategies under their

supervision, which enables them torespond to the changing conditions in

fixed income markets. The FI Risk

team also includes quantitative

analysts, who bring their own

distinctive insights to the management

of our bond investments.

The FI Risk units duties span a broad

spectrum of risk management

activities, from portfolio risk analysis

and performance monitoring and

attributions to the provision ofinsightful and timely quantitative

research that guides investment

positioning.


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Risk management Making the dierence in fxed income investing 5

A quantitative,investment-focusedapproach to risk

It is the teams quantitative,

investment-focused approach and

the development and deployment of

customised quantitative models that

set our fixed income risk team apart

from those of our peers.

In recent years, there have been many

occasions when the quantitativeanalysis provided by the FI Risk team

has validated the investment stance

taken, led to changes in a portfolios

positioning or been instrumental in

the development of new strategies

and risk measurement techniques.

Timely market risk monitoring

In one instance in the summer of 2013,

our risk team detected an unusually

abrupt shift in the risk profile of one of

our global credit strategies.

A deeper analysis revealed that the

spike in the portfolios annualised

volatility and Value at Risk (VaR)

stemmed from a tactical trade in credit

default swap indices and credit

default swaptions, contracts which

give bond investors protection against

the risk of default.

The FI Risk team immediately

informed portfolio managers of this

deviation. As it turned out, the

temporary shift in the portfolios risk

profile was intentional but required

monitoring nevertheless. The

investment and risk teams

subsequently worked in tandem over

the following days to ensure the riskexposure remained within target

levels.

FIG. 1 A SPIKE IN PORTFOLIOS SPREAD VOLATILITY PROVIDES A TRIGGERFOR HEIGHTENED RISK MONITORING

Source: Pictet Asset Management, Data taken from analysis of EUR High Yield strategy

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Total Ex-Ante Vol (%)

Interest rate

Spread

FX

Vega


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A multi-faceted risk approach

In response to the changing needs of

its clients, Pictet AM has launched a

number of innovative fixed income

strategies in recent years. Many of

these give portfolio managers the

discretion to invest across a broad

range of fixed income markets and the

freedom to express both negative andpositive views on securities and asset

classes. In order to provide investment

managers of these funds with the

clearest possible view of the risks in

their portfolios, the FI Risk team uses

several analytical tools that go beyond

measuring a portfolios TE or VaR.

These range from those that measure a

portfolios gross and net exposure to

more advanced metrics such as the

duration time spread (DTS) and theDTS ratio (see glossary), which are

used to gauge the portfolios credit

beta.

Standalone tracking error is another

measure that is regularly monitored to

gauge the risks a portfolio is exposed

to. Standalone TE breaks down a fixed

income portfolio's risk into its

individual components interest rate,

inflation, spread etc and looks at each

in isolation; in doing so, standalone TE

assumes there is no correlationbetween these factors. It gives

managers a clearer idea of the risk on a

specific position when another one that

diversifies it is closed. This risk

measure enables the FI risk team to

monitor the diversification within a

portfolio from various angles.

Portfolios are regularly submitted to

stress tests to assess the impact of

shocks on their returns. By modelling

a number of possible future scenariosfor each risk factor, the fixed income

risk team can forecast changes in the

value of the portfolios investments

and hence its overall gain or loss

under different market conditions.


FIG. 2 DTS ANALYSIS OF A CREDIT PORTFOLIO, BY SECTOR

FIG. 3 DIVERSIFICATION INDICATOR FOR VARIOUS FIXED INCOME PORTFOLIOS

Source: Pictet Asset Management


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Diversification ratio

Pictet-EUR Government Bonds fund Pictet-World Government Bonds fund

Pictet-EUR Inflation Linked Bonds fund PI CH-Foreign Bonds fund

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Basis points

Telecommunications Technology Sovereign Government Financial

Energy Cons., Non-Cyclicals Cons., Cyclicals Capital Goods Basic Industry

Index Other Sectors

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Practical quantitative guidance

The FI Risk team has also developed

models that allow investment

managers to understand the

behaviour of credit spreads, aiding

portfolio construction. For our

high-yield debt investment team, for

instance, our quantitative risk

specialists performed a detailedregression analysis of speculative-

grade bonds risk premia. The analysts

found that risk premium or spread

was heavily influenced by the

volatility of the European stock index,

the default rate of high-yield bond

issuers and the yield spread between

peripheral European and German

government bonds. The output from

this model has now become part of the

macroeconomic, or top-down, analysis

conducted by the high-yield bond

investment team.

An active role in product

development

The FI Risk team also has a major part

to play in the development of new

fixed income products, helping

formulate risk guidelines that serve

the investment needs of both clients

and portfolio managers.

During the development phase of

Pictet AMs new range of short

duration fixed income strategies, the

FI Risk team performed several

analyses aimed at establishing

investment parameters for the funds

in the product family.

For each of these strategies, the FI Risk

team was able to provide detailed

guidance on the suitability of

investments by maturity, credit rating

and currency. The analysis also

encompassed the selection of each

portfolios reference index, VaR limits

and country exposure caps.

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These positive interventions are

possible thanks to Pictet AMs

sophisticated risk management

system, an integrated RiskMetrics

platform.

The system uses advanced risk

methodologies and automated

risk analytics that enable it tomonitor and model the extent to

which an individual security

affects a portfolios risk-return

profile. It can also accurately

determine how a portfolios

exposure to different countries,

industry sectors and ratings

categories can affect its returns

and volatility.

The FI Risk team has adapted

and continously seeks toimprove this system so that it

meets the needs of our investment

processes. The credit model, for

instance, was recently enhanced to

more accurately capture a

portfolios idiosyncratic risks.

Each day, the team runs an

average of 30 sets of risk

analyses per portfolio that

capture changes in a portfolios

risk profile along a number of

different dimensions.

These analyses are based on two

types of daily risk reports themanager summary report and the

more detailed risk attribution

report. The manager summary

report provides a snapshot of the

portfolios risk exposure as

indicated by their VaR and

annualised TE/Volatility, grouped

by investment team. Alerts are

generated automatically whenever

a portfolios specific level of risk is

reached.

Through the more detailed risk

attribution report, meanwhile,

investment managers receive a

comprehensive analysis of the

sources of risk inherent in their

portfolios an in-depth risk

decomposition that captures the

proportion of a portfolios VaR

or TE/Volatility that is

attributable to interest rates,

currency, yield spread, volatility

and inflation.1

Fixed income riskmanagement inextricably linkedto the investmentprocess

1The risk team uses a number of

statistical tests to check the validity of

the risk model including the Kupiec

and Christoffersen tests.


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FIG. 4 REGULAR RISK MONITORING BREAKING DOWN VOLATILITY BY RISK TYPE

FIG. 5 DECOMPOSING RISK BY CURRENCY AND RISK TYPE

Source: Pictet Asset Management; Data taken from analysis of Absolute Return Fixed Income S trategy

Source: Pictet Asset Management; Data taken from analysis of Absolute Return Fixed Income S trategy

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Vega FX Total Ex-Ante Vol (%)

Spread Interest rate 10-Day VaR at 95% (%)

Ex-ante volatility, %

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USD-SPREAD USD-IR USD-FX TRY-IR NOK-FX NOK-IR

NZD-FX JPY-IR GBP-FX GBP-SPREAD GBP-IR EUR-FX

EUR-SPREAD EUR-IR DKK-IR BRL-IR BRL-FX AUD-FX

Other factors


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Ensuring reliabilityof risk models -

backtesting

To ensure our VaR risk model is

accurate and robust, its results are

back-tested regularly. The VaR figures

are checked against actual returns.

Backtests are carried out for all Pictet

AMs flagship funds every quarter.

Figure 6 shows the outcome of these

back-tests for one of our strategies.In this instance, the VaR models

predicted daily returns for the

Pictet-Local Asia Emerging Market

Debt fund are compared to the funds

actual returns. Under a VaR with a

confidence level of 95 per cent, the

proportion of daily returns falling

outside the VaR figure should be on

average 5 per cent for the model to be

considered reliable.

The green dots in Figure 6 show those

instances when the actual daily return

was in line with the estimate

generated by the model. The orange

dots below the red line indicate those

occasions when the realised return

was outside the predicted range. In

this case, the back-test confirms the

model was robust.

FIG. 6 ABSOLUTE VAR BACKTESTING FOR AN EMERGING DEBT PORTFOLIO


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Abs 1D-VaR-95% Percentage of exceptions: 4.5%

Basel Test

Kupiecs p-value: 0.562

Christoffersons p-value: 0.096


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Regular risk reviews

Risk budgeting

Performance attribution

The manager summary and risk

attribution reports also serve as the

basis for more detailed risk reviews

between risk professionals and their

investment counterparts.

Every week, members of the risk team

and investment professionals meet to

In addition, risk budgeting meetings

are held twice a year with

investment teams and the head of

fixed income. They give the FI risk

unit the opportunity to work with

the investment teams to:

- review the allocation of risk

between the different sources ofreturn for each portfolio over a set

period

- understand the reasons for any

deviation from pre-determined

risk budget targets.

The risk team complements its risk

analysis with the regular monitoring

of portfolio performance. Portfolioreturns are monitored on a daily

basis and unusual deviations are

analysed through a proprietary

performance attribution system.

Detailed performance attribution

analysis is also provided to

investment managers on a monthly

basis. This ex-post review allows

investment managers to review their

risk allocation.

discuss the results of the risk analysis

of their respective portfolios. The

reviews focus on metrics such as the

historical evolution of a portfolios

risk profile by VaR and TE/Volatility

the concentration of risk and the

contributors to risk.

In our view, an effective way to

dampen the volatility of returns and

keep unintended risks to a minimum

is to embrace diversification at every

stage of the portfolio construction

process. It is important to recognise

that each source of return is also a

potential source of volatility and risk.

This is why the risk team work closely

with investment managers to ensure

the portfolios risk budget is efficiently

distributed across a portfolios sources

of return (currency, duration, spread,

etc.)

A more comprehensive review is also

carried out at least twice a year. In this

process, Pictet AM managing partners,the head of fixed income, investment

managers, and the fixed income risk

team meet to analyse each portfolios

performance and risk exposure.

FIG. 7 MONITORING FRAMEWORK


Market risk management Performance monitoring and attribution

Daily Control of risk limits (TE, VaR) Monitoring of performance to identify

and analyse unexpected variations

Weekly Risk reviews by investment teams

Control of internal guidelines*

Performance analysis

Monthly

Semi-annual

Risk budgeting meetings by investment teams

Quality review meetings with the top management

Performance attribution adapted

to each investment process (YTD, QTD, MTD)

*Compliance department controls contractual guidelines and regulatory limits on a daily basis


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Concludingremarks

A risk management approach for a changing investment

landscape

The financial crisis and the monetary and regulatory shifts itunleashed have turned fixed income investing into a riskierenterprise. At Pictet Asset Management, understanding andmanaging risk has always been a fundamental part of the fixedincome investment process.

The strength of our risk management stems from two factors the first is that our fixed income risk management team has

developed a quantitative investment-focused risk managementapproach that is deeply embedded in the investment process.The second is that such analysis is conducted to ensure thatinvestment decisions are subjected to rigorous and impartialscrutiny.

In a period likely to be characterised by increased marketvolatility, this in an approach that benefits our investmentmanagers and, ultimately, leaves investors better placed to meettheir long-term investment objectives.

TEAM PROFILE

The FI Risk unit is a team of eight. The current head tookresponsibility for building the team in 2000, while most of the

team members have been working together for at least six years.Over time, this stability has enabled the team to develop arobust set of tools specifically designed for the analysis of fixedincome portfolios, which they have been adapting to respond tothe changing conditions in fixed income markets.


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Glossary ofrisk managementmetrics

The Value-at-Risk (VaR)of a portfolio

is an estimate of the maximum capital

loss that the portfolio can be expected

to experience within a specified

holding period, and with a specified

confidence level. Instead of expressing

the loss in absolute terms, Relative

VaR measures that loss relative to the

benchmark loss over the period. TheFI Risk unit VaR is based on a Monte

Carlo method in which 1,000 possible

scenarios are simulated.

Tracking Error (TE)quantifies the

degree to which the performance of a

portfolio differs from that of its

benchmark. It is defined as the ex-ante

standard deviation between portfolio

returns and the benchmark returns,

based on a parametric methodology,

which assumes that portfolio returnsare normally distributed.

Effective Durationis the approximate

change in a bonds price that will

result from change in its yield. It is

used for both conventional bonds and

those with embedded options or

redemption features.

Spread Durationmeasures the price

sensitivity of fixed income

investments to shifts in their yieldspread (the difference in yield

between the security and benchmark

government debt).

Effective Convexitymeasures the

effective duration change that results

from a change in a bond's yield.

DTS (Duration Times Spread)

captures the sensitivity of a bonds

price to a relative change of its yield

spread. It is calculated by multiplyingthe spread duration of a bond by its

credit spread (in basis points).

The DTS ratiocompares the

funds DTS to that of its reference

benchmark.

The diversification indicatortakes a

value between 0 and 1, with 1 being a

perfectly diversified portfolio.

(1-{Total Risk / sum of stand-alone

risk by category})

Basel test:The Basel Committee

recommends a recording of daily

exceptions of the 99% VaR over the

last year. 1 percent of 250, or 2.5

violations are expected on average

over the last year. The Basel

Committee has decided that up to

four exceptions are acceptable, which

defines a green light zone. Five or

more exceptions and the fund falls

into a yellow or red zone

Kupiecs p-value:The Kupiec test is a

statistic test that verifies if the

observed frequency of violations

(exceedances of VaR) is close to the

expected number of exceptions. The

VaR Model fails the Kupiec test if the

p-value of the defined statistic is

below a specific value. This test is

unconditional as it does not take into

consideration whether the exceptions

are independent or not.

Christoffersens p-value:This test

supplements the Kupiec test by testing

the independence of exceptions. It

formalises the notion that when

exceptions are not independent, the

probability of an exception tomorrow,

given that there has been an exception

today, is no longer equal to the

confidence level.


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Contacts

For further information, please visit our websites:

www.pictet.com

www.pictetfunds.com

This material is for distribution to professional investors only. However, it is not intended for distribution to any person or entity who is

a citizen or resident of any locality, state, country or other jurisdiction where such distribution, publication, or use would be contrary to

law or regulation.

Information used in the preparation of this document is based upon sources believed to be reliable, but no representation or warranty is

given as to the accuracy or completeness of those sources. Any opinion, estimate or forecast may be changed at any time without prior

warning. Investors should read the prospectus or offer ing memorandum before investing in any Pictet-managed funds. Tax treatmentdepends on the individual circumstances of each investor and may be subject to change in the future. Past performance is not a guide to

future perf ormance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get

back the amount originally invested.

This document has been issued in Switzerland by Pictet Asset Management SA and in the rest of the world by Pictet Asset Management

Limited, which is authorised and regulated by the Financial Conduct Authority, and may not be reproduced or distributed, either in part or

in full, without their prior authorisation.

For UK investors, the Pictet and Pictet Total Return umbrellas are domiciled in Luxembourg and are recognised collective investment

schemes under section 264 of the Financial Services and Markets Act 2000. Swiss Pictet funds are only registered for distribution in

Switzer land under the Swiss Fund Act; they are categorised in the United Kingdom as unregulated collective inves tment schemes. The Picte t

Group manages hedge funds, funds of hedge funds and funds of private equit y funds which are not register ed for public distribution within

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For Australian investors, Pictet Asset Management Limited (ARBN 121 228 957) is exempt from the requirement to hold an Australian

financial services licence, under the Corporations Act 2001.

For US investors , shares sold in the United States or to US Pers ons will only be sold in private placements to accredited investor s pursuant to

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Copyright 2014 Pictet - Issued in September 2014


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In-Depth PictetAM-FI Risk Managment