Stress testing is gaining popularity among institutional investors as a way to measure portfolio risk in abnormal market conditions, risk experts say.
Following the market gyrations of the past couple of years, investors want more information about how their portfolios might react in market cycles when economic characteristics fall outside a spread of normal conditions, as defined by a typical bell curve.
And the recent precipitous drop in the value of technology stocks adds a new wrinkle that could boost stress testing's popularity in the future.
Even Federal Reserve Chairman Alan Greenspan has touted the benefits of stress testing in several speeches. Speaking to bank regulators in 1999, he suggested investors might be underestimating their portfolio risk and said the least they should be doing is stress testing and setting aside reserves to cover potential losses stemming from market crashes and panics.
In a May speech to the National Association of Urban Bankers and the Urban Financial Services Coalition, Mr. Greenspan again advocated the approach. Although he was referring to testing lending portfolios, he could just as easily have been addressing equity risk.
"When strong conditions largely mask the susceptibility of marginal borrowers, stress testing is invaluable for revealing the magnitude of portfolio risk posed by more challenging economic conditions," he said.
Correlation and risk
Risk experts agree. Although all acknowledge stress testing cannot predict the future and has little application in figuring day-to-day risk exposure in current market fluctuations, they say it can give investors important information about portfolio correlation and risk.
"It gives us a forward-looking perspective of risk," said James Lam, founder and vice chairman of ERisk, New York, which offers risk management services that include consulting and Internet-based analytics. "Stress testing is widely recognized as a best practice for risk management."
For instance, had investors been stress testing three or four years ago, they might have plugged into their models scenarios involving a sudden, prolonged drop in the value of technology stocks. Then they could have seen whether they were appropriately diversified to cover the risk of such a drop.
But only the biggest pension funds stress test their portfolios, said Kelsey Biggers, president and chief executive officer of Measurisk LLC, New York. Between 80% and 90% of funds with more than $5 billion in assets do stress testing, he said. But those tests tend to be simplistic, Mr. Biggers added. And smaller pension funds are just now starting to see value in value at risk and stress testing.
"Smaller funds are just beginning to get past information ratios and data as a stand-in for risk," Mr. Biggers said. "The majority of funds at the smaller end think they have risk tools, but what they really have are volatility measures like standard deviation and information ratios."
One method of stress testing involves applying historical market moves to portfolios to gauge their risk if such an event occurred again. Another uses hypothetical scenarios considered well outside the range of normal possibilities.
The goal isn't to change portfolio composition based on the results, but to make people aware of what could happen given certain market conditions, Mr. Lam said. Investors need to know what they're betting on and what they're betting against, and how each of those bets will respond under stressful market conditions.
Identifying good and bad
"Through stress testing you can identify the positive and negative bets, and then ask what scenario would best favor our strategy and do we really believe that scenario will happen," Mr. Lam said. "You also want to know what scenario will really hurt our strategy."
Philip Best, managing principal at The Capital Markets Co. NV, an Antwerp, Belgium-based consultant, said stress testing can reveal that investments typically thought to be negatively correlated - with values moving in opposite directions in response to the same market condition - could be positively correlated, meaning they would move together. Take stocks and bonds, for example, he said. "Typically they move in opposite directions. But sometimes the opposite correlation breaks down and they move together."
Stress testing, he said, can reveal those kinds of events.