By John Dewey
The financial turbulence of the last decade didn’t just damage portfolios; it also dealt a blow to long-standing ideas about how to manage them. We believe that traditional approaches to asset allocation and risk management are unlikely to fare much better in years to come.
Investors have entered a new world of higher volatility, higher correlations among asset types and rock-bottom yields, with danger looming when rates finally do rise. Further complicating the picture is a new awareness that economic regimes are less predictable, and influence assets in a more complex manner, than investors once thought.
To thrive in this unforgiving landscape, portfolios must evolve. We advocate starting with the adoption of a more holistic risk management framework, one that incorporates what we call the ‘three Rs’: risk-factor-based allocation, regimes analysis and, crucially, risk management systems powerful enough to support the first two Rs. Investors must set their objectives more precisely than in the past. By using the three Rs to work towards specific investment outcomes – rather than just seeking to outperform a peer group or benchmarks – investors may be more likely to achieve their goals.
There’s little doubt that a new approach is needed given the recent performance of the average institutional portfolio. According to the UBS report Pension Fund Indicators 2012, over the decade to December 2011, the average UK pension fund returned just 5.9% annually, compared to 10.2% for the 49 years from 1963 to 2011.
The poor performance of the average institutional portfolio shows the weakness of asset classes as tools for diversification. Though the allocations appear diverse, they actually leave the portfolio primarily exposed to just one kind of risk: economic. To better diversify, investors need to go a level deeper and look at the risk factor exposures. Risk factors define the specific investment risks taken, with the goal of earning a long-term return premium. Six macro risk factors that are intuitive, investable and relevant across asset classes are real rates, inflation, credit, political, economic and liquidity risk. While each of these factors has been rewarded at different times and in any period, not all risk factors are rewarded. Betterbalanced exposures, achieved by allocating assets across risk factors, may lead to more consistent returns, and should insulate a portfolio from a shock caused by a single risk factor.
Investors also need to think more deeply about the path of the global economy – and the possible impact of different scenarios on their portfolios – what we call regimes analysis. How much growth is ahead, and which economies will participate? Will inflation finally flare up? What are the chances of a deep global recession? By incorporating this analysis and considering which assets or risk factors would do well (or poorly) in each regime, investors can better position their portfolios for future events.
Neither of the first two Rs is possible without the third: the high-quality risk management systems needed to understand risk exposures, to stress-test portfolios across scenarios, and to hedge portfolios against potential future regimes. With a more complete view of risks, investors are better able to take only those risks that are intended and that are most likely to be rewarded. Only by considering all three Rs – risk factors, regime analysis and risk management systems – can investors hope to revitalise portfolios and position them effectively to prosper in an environment of greater economic uncertainty.
John Dewey is managing director and member of the Client Strategy team at Blackrock Solutions
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