Scenario Analysis - The Way Forward

27 June 2014

Standard Life Investments, the global investment manager, considers a new approach to scenario analysis. The latest edition of Global Horizons examines in detail a new scenario analysis framework that has been developed by Standard Life Investments to explore potential portfolio weaknesses and tail risk. It is based on Entropy Pooling, which goes beyond the assumptions of traditional models to create richer scenarios that can be explained in terms of intuitive outcomes. This is an integral part of insuring that portfolio performance is robust in a diverse range of economic conditions.

Recent events in financial markets have reinforced the need to think seriously about tail risks as traditional risk systems were unable to warn of extreme losses and contagion across asset classes and markets seen during the financial crisis.

Jens Kroeske, Quantitative Investment Manager, Multi Asset Investing, Standard Life Investments, said:

Jens Kroeske

“At Standard Life Investments we want to construct robust portfolios that will better withstand tail events and meet our clients’ needs. We believe that the value of successful scenario analysis should not lie in the exact specification of portfolio gains and losses in a specific scenario. Rather, forward-looking scenario analysis should be a tool used to explore potential portfolio weaknesses through the interaction of subject matter experts that specify scenario shocks, risk managers that model the inferred losses and fund managers that can use the results to challenge and enhance their intuitive understanding of the behaviour of their portfolios in extreme scenarios. This is what the Entropy Pooling methodology helps to achieve. Ultimately, however; success lies in the process of interaction between investment professionals that it enforces. This means that a team-based approach will achieve the best possible outcome for clients.”

The report is authored by Jens Kroeske, Quantitative Investment Manager, Multi Asset Investing, Standard Life Investments.