Modeling Black Swans

GMI Ratings has long maintained that the increasing frequency of Black Swan events in capital markets will continue to challenge traditional approaches to risk modeling and portfolio management. For at least the past two decades, doubts have been mounting about the ability of classical economic theories and portfolio management philosophies to reliably describe, explain or predict anomalous trends and events in the stock market. Value-crushing scandals, such as those at Chesapeake Energy, Carnival, Wal-Mart, Halliburton, MF Global, News Corporation and BP have become all too familiar.

New Frontiers in Risk Modeling (pdf), by GMIRatings,  presents research reinforcing the following points:

  • The basic character of global capital markets has changed dramatically. Volatility has increased as has the frequency of anomalous events that defy classical economic theories, including Modern Portfolio Theory (MPT) and the Efficient Market Hypothesis.
  • The theoretical underpinnings of modern finance need to expand. By now, it is evident that much of the value destruction over the past decade resulted from operational and financial variables inadequately reflected in prevailing approaches to risk modeling and investing.
  • Investment managers and insurers can significantly reduce their exposure to unanticipated and mispriced risks by incorporating governance, ESG, forensic accounting and other non-traditional risk metrics into stock screening and selection, portfolio risk assessment and, for active managers, day-to-day dialog with portfolio companies.

GMIRatings develops tools to predict these anomalous trends. The latest results of their rolling 10-year study comparing the equity performance of companies with top-decile and bottom-decile Accounting and Governance Risk (AGR) ratings found to-decile outperformance of lowest-decile by 55%. Further, 57% of the companies that had Federal class action suits filed against them in the United States in the six months ended June 30, 2012 were correctly classified in the lowest-rated quintile a year before the lawsuit was filed. Only 2% of such companies were ranked in the highest quintile.

The report by GMIRatings cited similar findings by DB Climate Change Advisors in their report, Sustainable Investing: Establishing Long-Term Value and Performance:

  • 100% of academic studies conclude that companies with high ESG scores enjoy a lower cost of capital.
  • 89% of academic studies found correlations between high ESG scores and market- based outperformance.
  • 85% of academic studies found correlations between high ESG scores and accounting- based outperformance.
  • Governance (the G in ESG) remains the most important aspect of ESG metrics

GMIRatings concludes,

the “routinization” of anomalies primarily reflects flaws embedded in the system of perverse incentives that reward poor performance and excessive risk-taking…

broader adoption of ESG risk metrics – and a stronger emphasis on the underlying corporate practices – can boost investment returns while nudging the global economy toward a more sustainable foundation.

It may not be too late to reserve a place at The Future of Corporate Reform, GMI Ratings, 9/4-6/2012, Park City, Utah. I hope to see you there.

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