Risk & Reward

Olaf Scherf has spent more than a decade developing an innovative system for managing larger investors’ portfolio risk. We talked to him about how it works, the link between risk and return, and how a client relationship should thrive on transparency.

What exactly is a risk engineer?

I am a physicist by training, but my business card says that I do risk engineering. They’re not contradictory. As a physicist, I don’t look at the physical universe. Instead, I look at the universe of market risk and try to understand it in a more systematic way. As an engineer, I want to put in place systems that allow us to profit from this understanding. This is what my multi-asset risk engineering team and I do: we have created a new approach to this topic.

 

What got you interested in market risk?

In my case, it was the two-year slide in the markets after the dotcom bubble burst in 2001. It became clear that there was no consistent approach to dealing with market risk in a cost-efficient way. Traditional tactical asset allocation could boost performance and provide a degree of protection. But – as subsequent market events have also made clear – it cannot fully contain the effects of an overall market decline. And the use of individual options or futures to buy a guarantee of a certain level of performance remains expensive. Therefore, I wanted to find a more systematic and cheaper way of ensuring risk protection. And, rather counter-intuitively, I wondered if effective risk management could be done without having to perfectly predict the future – always a very difficult business! So I wanted a system that would work even if it was difficult to see what exactly lay around the next corner.

 

How does your approach work?

It is rather like those insurance comparison websites that offer you a range of quotes for your household or vehicle insurance. Essentially, we are doing this, but in a slightly more complex way.

 

If my team and I know your investment objectives and risk preferences, then we can monitor and assess – on a continuous basis – all the market options to ensure these objectives are met in a cost-efficient way. This requires complex calculations. A very large number of hedging solutions – possibly several million – must be compared with the underlying portfolio to identify the most efficient portfolio strategy for a given risk budget. Just as it makes sense for a hybrid car to sometimes run on petrol and sometimes on electricity, protection options will change over time.

 

But, to extend the insurance analogy, the key point is that when we estimate the probabilities of future returns, we assume a greater likelihood of big losses or gains than expected by most classical risk models. These losses or gains can dominate a portfolio’s long-term performance, so you need cost-efficient risk management that can encompass them – and, for example, avoid expensive stop-loss trades (asset sales at pre-determined prices) if the market falls. And, once this protection is in place, it may be possible to change the composition of the portfolio to boost expected returns.

 

Entrepreneur or intrapreneur?

I’ve done this work within Deutsche Bank, so I would have to label myself an intrapreneur. Innovation within a firm can create its own challenges. When I started in 2005, markets appeared healthier than they do today and I had to convince my colleagues that my approach was, first of all, worth the investment of time and money. Secondly, I needed to show that risk engineering would complement and reinforce their existing approach to portfolio management. My team worked tirelessly to develop our offering and the start of the financial crisis, in particular, underlined its importance on both accounts.

Who benefits from risk engineering?

Like any new product, as the environment changes, use can change. When we started developing risk engineering, we certainly did not anticipate the prolonged period of low interest rates that has prevailed since the start of the financial crisis. But, in many ways, this has made risk engineering more important.

 

This is because larger, more risk-averse investors (for example, foundations) have found it increasingly difficult to meet their investment objectives given the low returns available on bond-heavy portfolios. If we can manage to put an effective risk management system in place, then the client can, if they want to, change the composition of their portfolio to include higher-returning assets such as equities. In other words, you can boost likely returns without a corresponding increase in risk.

 

More calculations than conversations?

Actually, although this approach is mathematically-driven, it also involves a lot of client contact. We need multiple discussions to establish a client’s real risk-return preferences and how they want their portfolio to perform. Our approach needs to be highly tailored to the results of these discussions. This is part of the reason for our focus on larger clients. We also pride ourselves on transparency over risks, returns and costs. We want long-term client relationships.

 

 

OLAF SCHERF

Head of Risk Engineering

 

As published in WERTE No. 5, Deutsche Bank Wealth Management's client magazine