I recently embarked on a car-shopping excursion with my son. As part of the due diligence process, we went through a list of desirable features that each potential vehicle was expected to have. It immediately became evident to us that all salespeople, when confronting a parent/son set of prospects, are taught to discuss the safety attributes of their vehicle, whether we asked them about it or not. Their research must show that safety is a large concern for parents, whether we verbalize it or not, and they are right! Most parents would strongly discourage the purchase of a car that had a poor crash-test rating.

Financial advisors should be taking a “safety based” approach with their clients, regardless of their risk tolerance. Although the equity and debt markets have been relatively benign recently, memories of 2007–2009 are still fresh in the minds of both advisors and their clients. Prudence dictates that advisors perform crash tests on their portfolios to determine vulnerabilities as well as outcomes under various scenarios.

Prior to 2009, the tools available to independent RIAs for crash-testing purposes were limited. There were institutional software packages available that could do sophisticated macro risk modeling and scenario planning, but they were beyond the technology budgets of the average advisor, and they generally required a fair amount of training to use.

Since that time, a number of more affordable and user-friendly options have become available to advisors. Two of the better-known providers in the field are Hidden Levers and MacroRisk Analytics. Now a third firm, RiXtrema, is launching a software product called Riskostat that is designed to help advisors analyze the vulnerability of their clients’ portfolios to various macroeconomic risk factors as well as help advisors explore opportunities to hedge away some of those risks.

For those of you unfamiliar with the firm, RiXtrema is an investment risk and portfolio analytics company that serves institutional asset managers and financial advisors. They seek to differentiate themselves from the competition in two ways. First, all of their analytics are crisis-aware. Their models include patent-pending technology that addresses market behavior during times of crisis. Second, they focus on actionable analytics like portfolio crash tests and fund crash ratings as opposed to more traditional VaR and tracking error approaches.

RiXtrema Riskostat
Riskostat is RiXtrema’s first product that specifically targets financial advisors. It is available in two flavors: the standard desktop server program that you install locally on your own machine or a hosted model whereby the software resides on RiXtrema servers and you access it over the Internet. Both versions have identical functionality today. There’s also an iPad version that will soon be available on the App Store. It has the same functionality as the desktop version minus the trading capabilities. RiXtrema also has an API that software developers and integration partners can access.

I tried out the desktop version. To do so, I downloaded a zip file, extracted the contents and clicked on the executable file. When the program launched, my first impression of the main screen was that it was too busy and complex, but after playing around with it for a little while, I began to feel comfortable with it. At the top of the screen there are various drop-down menus. Right below that is another bar that controls various settings. The remainder of the screen is divided into three primary areas, but there is a lot going on in each, so it takes a little while to get acclimated.

One of the things that the folks at RiXtrema emphasized to me is that while becoming a power user of the software can take time, advisors can become proficient with the important basics fairly easily. After going through a few examples, I tend to agree. Perhaps the best way to illustrate the point is to take you through a real example.

In order to use the system, you need to create and name some portfolios. These can be your firm’s model portfolios, or they can reflect an individual prospect or client’s portfolio. My copy came loaded with four models, so to start, I selected the moderately conservative portfolio. To see the contents of the model, I clicked on the “trade utility” link on the bottom left of the screen, then I toggled back to the initial view. I then made sure my currency was set to U.S. dollars (other options are CFH, CAD, EUR, JPY), and then I hit the “read model” button to update the results.

On the left panel, there is a table of scenarios, created by experts at RiXtrema, and the expected consequences of each. For example, the “global stock crash” scenario currently shows an expected loss of -2.93% and a plausibility of 5.8 when applied to my moderately conservative portfolio. The latter number is supposed to measure how likely or similar it is to other crises over the last 20 years on a scale of zero to 100. All data is updated regularly to reflect current conditions.

These scenarios are illustrated in graphic form in the center panel as well, with green bars showing a positive outcome and red bars showing a negative one. Also in the middle screen, above the bar graph, is a “crash rating.” This rating tells you how “safe” the portfolio is in relation to the universe of mutual funds in the database on a scale of 1-10, with 1 being the safest. In this case, since the portfolio is moderately conservative, this portfolio scored a 2, but there are still scenarios where it will lose value. You can also select a peer group (e.g. equity income mutual funds) to see how risky the portfolio is versus your benchmark of choice.

When you click on a scenario, a box above the scenarios displays details concerning the event being modeled. For example, in an “emerging markets hard landing” scenario, as constructed by RiXtrema, the “shocks” they model are a scenario where Chinese and Indian equities drop 30% and Brazilian equities drop 25%. Users can edit the magnitude of the shocks, add new ones or remove shocks to create their own custom scenarios. For example, if a client held CDs denominated in Mexican pesos, you could create a custom scenario that included an increase or decrease of 20% in the peso’s value to illustrate the impact on the overall portfolio.

In the emerging markets hard landing scenario, when we look to the right, we see which holdings positively or negatively impact portfolio performance under the given scenario. In this case, it is no surprise that an emerging market fund fares worst. I can then click on the bottom right and the application will suggest hedges. For this scenario, the best hedge is a strategy that my client does not have access to, but the next best hedge is a ProFunds Ultra Short Japan fund that the client can buy.

Now, going back to the left pane, I have a number of options when I click on the trade utility. For example, if I am particularly worried about the emerging market scenario, I can just sell the emerging market fund. If that is not a good option for tax reasons, I can purchase a hedge. A better solution might be to click the “optimizer option.” I then have the choice of setting parameters and optimizing by crash rating or by specific scenario. Since I’m particularly worried about a specific scenario, I use the existing portfolio and optimize it with a target loss of no more than 1%, a maximum turnover of 20% and a maximum position size of 25%. When I run the optimizer, it is able to find a solution within my parameters that results in a maximum expected loss of 0.97%.

The trade-off is that the new portfolio would do worse under some other scenarios, but perhaps I judge those to be less likely, so I’m happy with the trade-off. If it was not able to offer a perfect solution, it would get me as close as possible given the constraints. I could also propose adding a hedge to the mix and re-optimizing. All of this may sound like a lot of work as you read it, but since my portfolio was already loaded, it only took me a few minutes to minimize the portfolio risk that worried me.

The example above only scratches the surface of what a more experienced user can do with the application. You can create your own macro scenarios that encompass a wide range of factors. You can create custom scenarios that address unique client situations. You can alter the look of charts. You can include an upside rating as well as a crash rating for portfolios if you want to. You can apply a modern portfolio theory (MPT) model as opposed to the RiXtrema model to view a different approach to portfolio risk. The risk charts that display in the center pane can be printed as PDF files and shared with clients.

Overall, there’s much to like about Riskostat. The iPad version is included in the subscription price. The people behind the firm are clearly very knowledgeable, and they are experienced. Many come from information providers like FactSet or served in risk management positions at major institutions and hedge funds like Moore Capital. I’m not smart enough to know whether their methodology is better than that of their competitors, so I’ll leave that for the reader to decide, but I can comment on the other aspects of the application.

As is the case with many products entering the market, Riskostat has a great deal of promise, but it is a bit rough around the edges. One thing in particular that plagues firms that come out of the institutional world is that they pay more attention to the quant side of things and less attention to the user interface.
That makes sense in the institutional world, but not in ours, where advisors need output that is appropriate for clients. Riskostat will be competing directly, for example, with Hidden Levers, a firm that has a great interface that is easy for advisors to master. Hidden Levers also produces great reports that are appropriate for use with clients. Currently, Riskostat does not compare favorably to Hidden Levers with regard to interface or graphics, but they are just starting out.

There are a few other areas that need work. One is the time it takes to start up the program. In my case, it took over a minute for the program to load; that’s something I hope RiXtrema can improve upon. The installation process needs work. I don’t mind downloading and extracting a zip file, but some advisors will (this should not be an issue with the hosted offering).

Each time you select a portfolio, you have to manually tell the application to “read” the portfolio in order to refresh the data. I’d like to see that process automated as well. Riskostat gives you two ways of looking at scenarios on the main screen (the chart on the left and the graph in the middle), but no way to directly view the makeup of the portfolio you are working on. You have to toggle to do that. I found that to be an unnecessary additional step.

Perhaps the greatest negative confronting RiXtrema currently is the lack of integration. You can import portfolios, or you can enter them manually, but advisors already have the data in their portfolio management software or on their custodial platforms, so why would they want to enter it again? As mentioned earlier, Riskostat has a rebalancing function that allows advisors to hedge away risk, but in order for the rebalancing tool to be really useful, it would need to work in concert with the intelligent rebalancing tools that advisors already own.

The vast majority of advisors have yet to purchase a macro risk management tool, but we think that will change the next time we experience some significant volatility on the downside. There are currently only two macro risk firms targeting advisors, so the market is not yet saturated.

With a suggested list price of $300 per month (some discounts are available), Riskostat is competitively priced. For RiXtrema to be competitive, they must establish integrations with the custodians at a minimum. Ideally, they should integrate with portfolio management, rebalancing and financial planning providers as well. Over time, they can tweak the interface and the graphics to make them more appealing as well.

For a firm that is just starting to serve advisors, RiXtrema is off to a promising start. With a bit of additional work, we think they can effectively compete in this small but growing software category. 

 


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