The effective management of risk has always been at the heart of successful fund management – a maxim that remains unchanged. What has changed, however, is the nature of that risk in a rapidly changing world
I entered fund management over 25 years ago, when certain correlations were a given, and wider, old-world hegemonies went unquestioned. Market machinations would be parcelled into formulae, and the Holy Grail was to beat the benchmark. However, times are changing rapidly, and fund management, in its entirety, should reflect this (or so the theory goes).
In the immediate wake of the credit crisis, when we all received a rude awakening, risk as a concept was scrutinised. As tends to be the case with human nature though, complacency sets in as quickly as lessons are forgotten. This meant how we view and handle risk never really received the wholesale assessment it required.
The butterfly effect
In a globalised investment world that is increasingly reflective of chaos theory – the ‘butterfly effect’, where small differences in one part of the world produce a disproportionately larger impact in another – we believe now is the time to question whether traditional approaches to risk management are entirely relevant or are, in fact, hindering returns?
As recently as 10 years ago, it was inconceivable to most that China and India would be gearing up as economic powerhouses: hitherto ‘risk-free’ assets would tumble; peripheral eurozone economies would threaten widespread contagion. Yet some popular models and practices still try to squeeze these developments into dated formulas and precepts, and still attempt to support attractive returns. We think today’s risks are far too unique for that. To coin a phrase, in the ‘new normal’, there are fewer safe havens, but there are many more opportunities to make money if assets are allocated with some dynamism.
With this in mind, it makes little sense that investment models continue to rely on historic data, based on past economic and business cycles, to assess future risk. Since the turn of the century, we have witnessed a ‘bull’ market in G7 government bonds, with some lower-risk strategies maintaining high weightings to these assets. Yet, with sovereign debt still vulnerable in the long term in the UK, US and Europe, shouldn’t we be asking ourselves if old risk models that have not factored in this new information carry any relevance in modern portfolio management?
Balancing act
Another important risk that has firmly entered the equation is that of greater political intervention. Over the last decade, central banks have controlled global monetary policy and politicians have happily relinquished fiscal discipline – it has all been a bit ultra-easy. In addition, imported deflation from China has masked the true, uglier nature of the economic cycle. However, as growth collapses and the boom years fade, the authorities face a treacherous balancing act between fiscal restraint and incentivising growth – the UK being an obvious case in point. Public outrage, once the more austere measures take hold, could ultimately heighten the risk of policy error. Other recent examples of political intervention include the proposed super tax on mining profits in Australia, the US’s criticism of BP, and Germany’s ban on naked short-selling of European sovereign debt. Asset allocation must also reflect this growing risk.
Hedge funds and other alternative investment strategies are one way of insulating against risk, by providing uncorrelated returns. Should markets move sideways, accompanied by extreme volatility, these strategies should significantly outperform index-tracking models, in terms of both risk and returns. The collapse of Lehman Brothers cast a large shadow on the reputation of hedge funds, but it would be foolish not to view this as an exceptional event: hedge funds still offer a very important off-set against risk.
While the investment landscape adapts to a rapidly changing world almost daily, the management of investment risk, like so many aspects of investment practice per se, needs to keep up. Portfolio management requires a multi-asset approach, because that which worked as little as 10 years ago may not work today. Our current world view of increased volatility and inflation ahead, advocates exposure to assets based in dollars, large-cap, global equities with strong franchises and balance sheets, gold, emerging market debt, a healthy exposure to specific alternative investment strategies, and no exposure to gilts. Within equity markets, we like Germany, given its strong economic management – good-quality export companies, and a currency that is being allowed to devalue. Elsewhere, we are tactically overweight the US, and we are avoiding Europe (ex Germany). We expect to be adding to our Asian and emerging markets positions on any pull-back relative to developed markets.
We live in exceptional times, with new precedents emerging while others crumble. In the most extreme environments, the one thing that increases is correlation. By injecting some much-needed realism into how we view risk, investors may help smooth the deeper cycles the changing world now suggests.
David Coombs, manager of the Rathbone Strategic Growth and Rathbone Total Return portfolios
