Measuring Risk in 2018

1© 2018 Windham Capital Management, LLC
1
Measuring Risk in 2018
Lucas Turton
Windham Capital Management, LLC
Managing Partner & Chief Investment Officer
Confidential. Not for redistribution.
March 2018

Agenda
i. Results from a 2007 study published by Windham Capital Management
ii. Evidence of risk regimes
iii. Within horizon risk estimation

Moderate Allocation
US Stock 35%
Foreign Stock 24%
US Bonds 33%
Real Estate (REITs) 3%
Commodities 5%
Expected Return 8.4%
Standard Deviation 10.1%
From “Asset Allocation” M. Kritzman and L. Turton, November 2007
Traditional Value at Risk (VAR) estimates this portfolio has a 1%
chance of falling 9.9% or more over a five year period

Moderate Allocation
US Stock 35%
Foreign Stock 24%
US Bonds 33%
Real Estate (REITs) 3%
Commodities 5%
Expected Return 8.4%
Standard Deviation 10.1%
From “Asset Allocation” M. Kritzman and L. Turton, November 2007
In a 2007 paper, we estimated this portfolio had a 1% chance of
losing 35.1% or more over a five year period.

Out of Sample Results
Loss
Value at risk estimated naively 9.9%
Value at risk estimated by Windham in 2007 35.1%
Realized cumulative loss during 2008 financial crisis 29.4%
Realized maximum drawdown during 2008 financial crisis 35.5%

Conditional Correlations
The only problem with diversification is that it has never been tried.
- Correlation of U.S. and non U.S. stocks when returns are
one standard deviation above their means: -17%
- Correlation of U.S. and non U.S. stocks when returns are
one standard deviation below their means: +76%
Based on returns from January 1979 through February 2008.

Equity returns tend to be non-normally distributed
Histogram of daily returns, Wilshire 5000, January 1999 – September 2015, Source: Datastream
0
0.5
1
1.5
2
2.5
3
Full Sample
Full Sample

Regime dependent return distributions are normally distributed
Histogram of daily returns, Wilshire 5000, January 1999 – September 2015, Source: Datastream
0
0.5
1
1.5
2
2.5
3
3.5
Turbulence Distribution Breakdown
High TI Low TI

The portfolio is daily rebalanced consisting of 60% broad US equities (Wilshire 5000) and 40% broad US fixed
income (Barclays US Aggregate)
* Data for 2015 through September, Source: Datastream
13.5% -1.8% -3.0% -8.8% 20.3% 9.3% 4.9% 11.2% 6.5% -21.1% 20.1% 13.4% 4.6% 11.4% 17.9% 10.2% -2.6%
0%
5%
10%
15%
20%
25%
30%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015*
Dynamic Risk and Portfolio Returns
Risk
Return
Average Risk

Understanding Turbulence
 We use a proprietary turbulence measure to differentiate calm markets from turbulent markets.
 Spikes in the Turbulence index coincide with well known market events
 Turbulence tends to persist in the market
0
10
20
30
40
50
60
70
TurbulenceIndex
Quiet Turbulent
Global Financial Crisis
9/11
Tech Bubble
Russian Default
Gulf War
Black Monday
Stagflation
Turbulence Index 1980 - 2009

Understanding Turbulence
 Turbulent periods are
characterized by
statistically unusual price
movements in the global
markets
 Turbulence is superior to
VIX because it considers
all asset classes and
takes into account shifts in
correlation
Asset1
Return
Asset 2 Return
Turbulent outliers with two correlated assets

Within-Horizon Risk Measurement

Example:
We invest $100 in a portfolio with an expected return = 8% and expected risk =
12%. Our investment horizon is five years.
Question:
What is the likelihood that our portfolio is worth $85 or less?

Example:
Answer:

Example:
Answer:
Five years from today there is less than a 1 in 50 chance that the portfolio is
worth less than $85.

Example:
Answer:
Five years from today there is less than a 1 in 50 chance that the portfolio is
worth less than $85.
However, there is a 1 in 7 chance that the portfolio is worth $85 or less at some
point over the next five years.

Example:
What does this mean?

Example:
1) Within-horizon risk is far greater than traditional end of horizon measures.

Example:
1) Within-horizon risk is far greater than traditional end of horizon measures.
2) Time does not diversify within-horizon risk.

Capital Market Assumptions
Asset Class Return* Risk**
Global Equity 8.0% 16.4%
REITs 9.3% 25.4%
Gold 5.4% 20.6%
Hedge Funds 5.5% 8.5%
US Fixed Income 3.0% 6.5%
* Global CAPM from Windham Portfolio Advisor
** Historical Risk from 8/2005 to 12/2017

Optimal Portfolio
34.0%
9.0%
7.0%
32.0%
18.0%
Optimal Asset Allocation*
Global Equity REITs Gold Hedge Funds US Fixed Income
* Mean-Variance optimal portfolio constrained to 10% risk

Portfolio Risk – One Year, 1% VaR
Loss
Value at risk estimated naively 7.8%
Within-horizon Value at risk with turbulent risk 26.7%

Conclusions
 Downside risk measures must consider asset class risk and correlation during
periods of market turbulence
 The investment path matters
 Including Global Financial Crisis in your model doesn’t ensure realistic loss
assumptions
 Long live quant models!

Upcoming Webinars:
Windham Software Overview
Thursday, March 8th at 1PM EST
Investment Challenges in Rising Rate
Environments
Guest Speaker: Andrew Weisman
Wednesday, April 11th at 1PM EST
https://www.windhamlabs.com/webinars/

Thank you!
Questions? Contact us at info@windhamlabs.com

Disclaimer
The information contained in this presentation (the “Presentation”) is prepared solely for informational purposes. The Presentation is neither an offer to buy or
sell nor a solicitation of an offer to buy or sell any security, or interests or shares in any fund or strategy. Historical data and other information contained
herein is believed to be reliable but no representation is made as to its accuracy or completeness or suitability for any specific purpose. Past performance is
not indicative of future performance, which may vary. There can be no assurance that the strategies’ investment objectives will be achieved. All strategies in
this Presentation place investor capital at risk. Future returns are not guaranteed and a loss of principal may occur.
References to market or composite indices, benchmarks or other measures of relative market performance over a specified period of time are provided for
your information only. Reference to an index does not imply that the Windham portfolio will achieve returns, volatility or other results similar to the index. The
composition of a benchmark index may not reflect the manner in which a Windham portfolio is constructed in relation to expected or achieved returns,
investment holdings, portfolio guidelines, correlations or tracking error targets, all of which are subject to change over time.
Prospective investors should not rely on this Presentation in making any investment decisions. Windham’s portfolio risk management includes a process for
managing and monitoring risk, but should not be confused with, and does not imply, low risk. Asset classes and proportional weightings in Windham portfolios
may change at any time without notice. Windham does not provide tax advice to its clients and all investors are urged to consult with their tax advisors with
respect to any potential investment.
Please refer to Windham’s ADV Part 2A for additional information. Windham and its owners disclaim any and all liability relating to this Presentation, including
without limitation any express or implied representations or warranties for statements contained in, and omissions from, this information.

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