Special Focus: Returns-based Modeling
Along with position-level transparency risk, Cognity also measures returns-based risk. Having both position and returns-based risk analysis integrated on the same platform brings additional insight. While position-based risk provides a snapshot based on the current portfolio holdings, returns-based factor risk analysis takes into account trading dynamics and style changes, providing a longer-term strategic perspective.
Returns-based modeling requires special attention to deal with the following problems:
- Short Histories
When working with multiple funds, it is often the case that one or more of them does not have the same length of history as the rest. This creates a problem because standard covariance matrix estimation requires equal history for all funds. Cognity provides a full suite of methods to deal with this.
- Factor Profiling
An important practical question when dealing with multi-manager portfolios is the relationship of the fund returns to major markets or sectors. Since in most cases the fund is exposed to a number of markets or sectors, discovering these relationships through regression analysis is essential.
- Style Drift
When building a multi-manager portfolio, funds are usually selected based on the strategies that they follow. Selecting funds that belong to different strategies provides diversification in the portfolio. The strategy that a fund follows may change significantly over time. This is known as style drift.
- Autocorrelation
Properly computing the risk of a multi-manager portfolio depends not only on how funds returns depend on markets and sectors but also on how past performance influences future performance.