Tracking error to measure and predict investment risk

KBC Asset Management is a provider of investment products and services. It forms - alongside KBC Bank and KBC Insurance - one of the three pillars of the KBC Bank and Insurance Holding; the three pillars were separated out under Belgium's new financial services legislation. It manages assets totalling over EUR 70 billion for a wide range of clients, including individual and institutional investors, and runs a number of collective investment funds.

The Challenge

The challenge was to develop a client/server application that would allow risk analysts to calculate track-ing error within portfolios and to predict future error. The application would have to measure risk at the level of the global portfolio as well as at the level of detailed portfolio composition. It would also have to calculate how the tracking error was attributed across the portfolio.

The Solution

KBC Asset Management and its partner, SOLID Partners, developed a SAS/Frame application pro-gramme, which provides a tool for fast tracking error computation and reporting, thereby enhanc-ing the company's portfolio composition, and the services and products it provides.

Measuring the risk

The financial markets have long been particularly dependent on the power of IT to carry out their operations. More and more, financial service providers seek to harness the full potentialof IT to back up the expertise provided by their advisers, and to provide them with powerful tools for decision-making.

For an investment services provider, being able to measure and manage risk is a key concern. Portfolio managers need to be able to stick as closely as possible to the benchmarks which are set for their portfolio's sector, and the departments which plan for portfolio composition need to assess future risk within the various bonds and equities they may wish to choose from. Measuring the risk, and using these measurements to control risk, are the key objectives of tracking error.

Tracking error measures the risk of a given portfolio relative to a benchmark set to represent the performance of the relevant portion of the market. It is pro-duced through a standard deviation of the return differences between the portfolio and the benchmark.

Calculating the tracking error

Linda Demunter, a Risk Analyst at KBC Asset Management, is aware of the importance of tracking error, and of the problems faced by risk assessors in try-ing to work it out: "Traditionally, portfolio managers would make their own assessment of risk. While they had a good idea of what the expected returns would be, they did not necessarily have a clear view of the risk," Linda Demunter explains.

It was therefore decided to look at an IT-based system of processing the wealth of information available about equity and bond movements to assess track-ing error on an ongoing basis. Linda Demunter teamed up with a colleague from her department and with two con-sultants from SOLID Partners. "The sys-tem we had in mind needed to be able to assist up to 15 risk analysts or portfo-lio managers, and had to fulfil a number of functionalities. We wanted to use the system to calculate the tracking error over a period of time, which has elapsed: the ex-post calculation. An ex-ante prediction would take existing data and project this performance in order to provide predictive view of tracking error to help managers make strategic deci-sions on portfolio composition. Ex-ante prediction would also be available, for use by fund managers who are tracking their own portfolios, in order to control the risk of their portfolio in relation to a certain benchmark."

KBC

KBC became the first company in Belgium to harness the power of SAS/IntrNet™ software on a mainframe computer, to add flexibility and ease of use to its IBS System.

Management decision support

The system needs to be able to decompose the prediction of tracking error: to measure performance against other variables, so as to provide key input for management decisions. For bonds, this means looking at currency exposure and interest rate exposure in the different currencies. For equities, it has to look at four different regions and twelve sectors of activities. And for bal-anced portfolios, the system decom-poses results into asset classes, cur-rencies, regions and sectors. It can cover historical periods of three months, six months or a year, and can provide returns on a daily, weekly, or monthly basis.
Françoise Grandjean of SOLID Partners, KBC's Asset Management's consultant, outlines the choice of sys-tem: "We chose a SAS/Frame 6.12 client/server application which would be up to managing the complex data extractions, updating the inputs regu-larly for the purposes of fund composi-tion. It is perfectly suited to running or showing a range of different analyses."

Working faster and more efficiently

There are two main sources of input data: the composition of the various funds, which is set out in a database format, using SAS Connect, and the various information relating to the finan-cial market's performance, which is delivered by financial data providers such as MSCI or JP Morgan, often in a spreadsheet format. Then there are a number of reference tables, which con-tain information on the bench weights, initial weightings for analysis, and geo-sector code translations.

"Downloading the data is in many respects the most difficult part," explains Linda Demunter. "The sheer volatility of the markets also represents a challenge for the system: sometimes equities can be split over the reference period, so quite a lot of manual check-ing is required if performance over a period of time is being compared."

Plans are already being made for an upgrade: "Next steps for the system are to reduce some of the manual oper-ations currently required for data input,and to migrate to SAS v 8.2," says Françoise Grandjean.

Linda Demunter is pleased with the results so far: "Prior to this, fund man-agers had no real tool to compute tracking error in a flexible way, but would have to rely exclusively on Excel files and on manual work. The new sys-tem allows them to work out tracking error fast. It's also a key tool for our Allocation Committee, when deliberat-ing portfolio composition: it allows them to enhance their decision-making."

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