Q: What does SmartRiskTM do?
A: SmartRisk uses a heavy-tailed model to provide more precise portfolio risk measurement, because the actual risk of big losses in client portfolios is much greater than the standard deviation calculation would suggest. SmartRisk doesn’t show what we think will happen; it’s what could happen. This more realistic estimate of risk allows advisors to have a conversation with the client in advance of the next downturn, and set reasonable expectations. In addition, once an advisor sees that much larger downside possibility, they can start looking for ways to mitigate the risk.
Q: If I don't use model portfolios for clients; each portfolio is customized. What’s the benefit of SmartRisk for me?
A: SmartRisk will help you communicate portfolio risk to your client in a meaningful way. You will be able to set proper downside expectation, potentially preventing a behavioral mistake in the next market dip.
Q: How does the software measure the risk? What are the parameters?
A: SmartRisk uses the 99.5% expected tail loss (ETL) of a proprietary heavy-tail model or distribution. Loosely speaking, it's the average of the worst 0.5% returns of the portfolio.
Other risk software uses the Gaussian model to calculate risk. Because of the Gaussian model's simplicity, and low computational requirements, it has survived in financial literature from the 1950s to the early 2000s. As inexpensive, massive computing power has become widely available, sophisticated market participants have switched to more realistic models known as heavy-tail models. This is what we use in SmartRisk. Heavy-tail models account for extreme market events that happen far more often than traditional models would predict - these are the times our clients are most likely to make bad decisions. You can learn more about heavy-tailed models and how we calculate risk in our white paper: The Risk Evolution.
Q: Does SmartRisk analyze the asset class information that an individual stock, bond, mutual fund (active or passive) or ETF is assigned or does it look at the actual performance characteristics of the holding when you run the analysis?
A: SmartRisk does not use the benchmark/asset class. It uses the information of the ticker symbol/individual holding. In the great majority of the cases, this allows for a more precise estimation of portfolio risk. There are cases where this would not necessarily be the best method, for example, for a mutual fund with a very short trading history. In these cases, we recommend that the user uses his/her own discretion. It is relatively easy to replace a holding with another holding with similar risk characteristics. For example, if there was a brand-new ETF that tracks the SP500, you could consider replacing that holding with, say, SPY. Also, if there are un-recognized symbols (e.g., non-traded assets, or individual bonds), SmartRisk allows the use of ‘Smart Symbols,’ which make for an easy substitution in the clients’ portfolios, and are designed to give a better view of the risk.
Q: Why does the drawdown analysis only go back to 2006? Can I go back further?
A: January 3, 2006 (the first trading day of the year) is statistically significant. From a statistical sampling point of view, going back to January 2006 provides enough data to estimate risk. This is a static date to ensure the sample includes a flat, bull and bear market.
Q: I've been telling my clients that their portfolio is diversified, but your asset interaction chart tells me that the portfolio is focused (or hedged). What's going on?
A: When diversification is not based on analysis with mathematics, diversification has a different meaning. Simply having "lots of securities" in a portfolio does not mean it is diversified. Assessing diversification has very little to do with the number of asset classes in a portfolio, or statistical correlations. A portfolio could be comprised of hundreds of stocks with low correlations during quiet times, and indeed offer low to no diversification. The simplest way to explain a diversified portfolio is if some securities in a portfolio "zig" when the others "zag," then they offset each other's risk. Learn more about asset interaction.