Traditional risk measures “considerably understate” downside risk over a given period, and the cost of illiquidity measures needs to be recalculated, according to Chirag Patel, head of the EMEA region at State Street Associates.

Speaking at the IPE Awards Seminar in Noordwijk, the Netherlands, Patel urged investors to revisit their illiquidity measures, as most of them “do not take investor specifics into account”.

These include rebalancing or capital calls one has to meet, the ability to use market-timing skills, or the cost of failing to make use of such skills.

“Quantifying these benefits or penalties shows the true cost of illiquidity,” he said.

The Norwegian Government Pension Fund Global (NPFG) recently approached State Street with the view to applying its new illiquidity assessment to the oil fund’s NOK4.5trn (€560bn) portfolio.

The results of the assessment are to be published in the first quarter of next year in a paper co-authored by Patel and David Turkington entitled ‘The Shadow Price of Liquidity in Asset Allocation’.

In the case study, the investor considers allocations to private equity, real estate and infrastructure alongside a public equity and bond portfolio.

State Street found that, with the NPFG, the “shadow cost” of liquidity was less than 1%, but it warned that the figure “may be higher for other investors”.

For Patel, another misconception in portfolio construction is the “correlation coefficient described from long-term averages”.

Looking at upmarket and downmarket periods, there are “only very few” assets that exhibit the desirable correlation asymmetry.

“Risk-averse investors choose negative correlation in downturn markets, but it’s OK for them to have correlation in upmarket phases – in traditional relation measurements, this is not taken into account,” he said.

Patel stressed that this rethinking needed to be done no matter whether a quantitative or qualitative approach was taken, as portfolios were “always built with some kind of correlation assumptions”.

“And if those break down, the portfolio unwinds, hedges are no longer holding and de-correlation no longer works,” he said.

According to State Street’s figures, assets with key risk premiums – including global equities, small equities, growth equities or hedge funds – exhibit “significant underperformance” during 10% of the most turbulent periods.

“It is not only about high volatility – looking at big moves in certain directions is much more important than looking at volatility alone,” he said.

In addition to reassessing illiquidity and correlation, State Street has also developed a risk measure to take “realised rather than perceived” volatility into account.

“Most investors continue to rely on bar and loss measures that are very much ‘end of horizon’ – for example, a five-year period,” he said.

“But, in practice, you are not going to hand an asset manager your money and come back five years later – you care about risk during the period.”

According to observations by State Street, a standard Value-at-Risk measure for a conservative portfolio at the end of 2006 was calculated at 2.1%.

An amended VaR that takes into account the risk in the most turbulent periods sets the risk at a 26.3% loss.

When State Street looked back at what happened two years later, the real loss in the portfolio was around 25.8%.

“We are trying to describe risk parameters in turbulent versus quiet periods,” Patel said, adding that it depended very much in which periods shocks were happening, as shocks in rough periods reverberated to a much greater degree.