May 10, 2010

With the mechanics of the global financial crisis coming into focus, portfolio modeling is getting a fresh look. "Modeling processes are definitely changing," asserts Dushyant Shahrawat, senior research director with TowerGroup. "People are adjusting their portfolio models to account for more types of extreme events, such as real estate crises or environmental disasters. And they are rethinking dramatic liquidity declines to avoid getting caught in another liquidity trap."

Calculating the correlations between asset classes is also getting an overhaul. "In 2008 when everything went down at the same time -- stocks, bonds, currencies and many commodities -- the correlations between those asset classes suddenly shot up," Shahrawat says. "This took the entire industry by surprise. So portfolio managers are now factoring in high correlations that occur during periods of market distress."

To accommodate the new market realities, firms must either adjust their existing software or adopt a new solution. "Although you can tweak your existing modeling tools, portfolio managers should also be keeping an eye out for anything vendors might be doing to address portfolio management and modeling in a different way," advises Shahrawat.

The 3-D Experience

According to some asset managers with decades of modeling experience, three-dimensional portfolio modeling best addresses recent paradigm shifts in the market. "During my 28 years in the business there hasn't been a time when it was revealed that so much systemic risk had metastasized into the system," says Vincent Rossi, president of Intelligent Capitalworks in Scottsdale, Ariz. "As a result, we've adopted Gsphere to study how to improve the benefits of portfolio diversification and reduce exposure to systemic risk."

Gsphere, by Denver-based Gravity Investments, is believed to be the only 3-D tool currently dedicated to portfolio modeling. On the market since 2003, Gsphere works by measuring diversification, while most 2-D tools focus on attempting to measure risk, according to Rossi.

Although Rossi first heard about Gsphere in mid-2007, he says he was motivated to investigate the software late last year while rethinking portfolio construction in light of the financial crisis. "We very quickly recognized the richer and more granular analysis available using Gsphere," Rossi relates. "It provides a great deal of insight into a portfolio's overall diversification and balance, especially when markets are in extremes."

Much as 3-D images have transformed medicine, Rossi believes 3-D tools such as Gsphere hold the same promise for portfolio modeling. "A good analogy is an X-ray versus and MRI," he explains. "An X-ray provides important information, but an MRI provides much richer information. Similarly, Gsphere has helped us glean a lot of insight for how to change the architecture of portfolios going forward."

"For example, you can parse out and study how asset classes have behaved," he continues. "You can also perform analysis by anticipating scenarios or assigning various probabilities. Plus, Gsphere is the only software I've seen that allows you to separate risk into systemic and non-systemic components and then deal with them differently in portfolio construction."

Using 3-D modeling also addresses the 2-D limitation of correlating assets as pairs, Rossi asserts. "There are few people who can glean the nuances of information presented in a two-dimensional table of 30 rows by 30 columns," he comments. "In 3-D, each asset's relationship with all of the others in the portfolio leaps off the computer screen."

And Gsphere is fast, Rossi adds. "You start receiving information as quickly as you can type it in," he says.

Stephen Maggart, an asset manager with Nashville, Tenn.-based Aintree Capital who has an engineering background, is equally impressed with 3-D modeling. "Gsphere is a technical solution that is much more involved than typical retail modeling tools," he emphasizes.

A former systems engineer who worked on NASA's next-generation Orion space craft, Maggart has used Gsphere for about 18 months. "It's a powerful solution that has helped us in numerous ways, such as eliminating redundant positions and reducing measured risk by 15 percent," he relates.

Modeling Opportunity

According to Ted Schwartz, a principal at Capstone Investment Financial Group in Colorado Springs, Colo., the improved insight enabled by 3-D modeling has contributed to asset growth over the past two years. "All of our client segments have had positive returns and are ahead of where they were when we began using Gsphere in January 2008," he reports. "And it occurred with much less volatility than the typical portfolio experienced over that period."

Yet it's not just about the assets themselves. Sophisticated modeling software also can assist with managing client relationships in the post-crisis world, notes TowerGroup's Shahrawat. "Client attitudes have changed, which you must accommodate during the modeling process," he comments.

Indeed, seasoned asset managers report that their clients and prospects want more insight into investment strategy and portfolio composition than ever before. "We recently met with a new client who was very interested in what types of analytic work we performed," recalls Intelligent Capitalworks' Rossi. "It was clear no one had previously responded to his question with anything better than a canned presentation."