For several years before 2008 equity risk – the model-based
expectation of how much markets are likely to vary – had been unusually low as
markets around the world climbed slowly and steadily. With steady returns and a
strong global economy, investors were not overly concerned about risk. In the
wake of the Lehman collapse, however, equity risk surged abruptly to record
levels. In the three months from mid-September to mid-December 2008, volatility
for the FTSE Developed Europe Index doubled, as did that of the US market’s
Russell 1000. The changes were even bigger for some individual countries; for
example, Germany’s predicted equity risk tripled.
At the same time,
correlations (a measure of how closely assets are moving together) increased
dramatically. The increase in correlations was evident between equities within
a country, between equity markets across countries and across asset classes.
Asset owners found their portfolios were not only down, but also far less
diversified than they had believed. In other words: where they expected
movements in one set of assets to be unrelated to those in another set of
assets, all assets moved together.
Funding levels of many pension
plans fell substantially, resulting in pressure to seek higher returns balanced
against the risk of further shortfalls. In the months after Lehman’s demise,
many asset owners shifted to assets perceived as less risky. However, those
did not necessarily provide shelter from the storm, and their low returns, even
if positive, did not help the underfunding situation. After March 2009, risk
began to trend down, and asset owners and asset managers began to breathe a
collective sigh of relief. However in May 2011, that sigh turned to a gasp as
risk once again trended up sharply on concerns about eurozone sovereign debt –
and made clear to everyone just how fragile the market recovery was.
The Rise of Risk Models
The increase in volatility
and lack of diversification, combined with the need to attain better
risk-adjusted returns, has led to an increased focus on financial portfolio
risk and the adoption of both risk measurement and risk management tools.
Sponsors needed to know how volatility would affect their managers, their asset
classes and their overall portfolios.
Plan sponsors and their
representatives were no less demanding in asking more of their managers. Of
course both sides have always sought the best possible portfolio returns, but
today’s asset owners are increasingly focused on what risk factors are driving
those returns. In addition, they are asking their managers to display an
understanding of how risk will affect their portfolios and to demonstrate that
returns have been the result of deliberate bets, not unintended exposures.
Use of risk models and risk management tools – once the exclusive
province of quantitatively driven managers – are now being deployed by growing
numbers of traditional fundamental managers. To some extent this is driven by
those whose assets they manage, but the managers themselves also recognise that
unintended risk exposures can have a huge impact on their returns, and
sometimes swamp the benefits of a good stock-selection process.
Evaluating Risk across Asset Classes
are also becoming increasingly aware that each asset class cannot be viewed in
a vacuum. The need for models that can evaluate stocks, bonds, commodities and
other classes all at once is more apparent, as the consequences of sets of
assets moving together and not ensuring diversity remains an unsettling memory.
This trend has also been fuelled by the continued globalisation of
markets and increased investor interest in risky but potentially rewarding
asset classes, such as emerging market debt and frontier market equities. Risk
models can effectively evaluate relationships within and between asset classes,
knowing which bets might offset or heighten each other, and help ensure that
multi-asset-class portfolios are well diversified.
While many variables
contributed to Lehman’s downfall, one of the precipitating factors was the
mortgage debt crisis. After seeing the impact that problems in one economic
sector can have across entire markets – the debt problems that crushed the
housing market extended well beyond the financial sector, filtering across
countries – managers and asset owners recognised the need to understand the
impact that macroeconomic factors have on their portfolios, and to be able to
model ‘what-if’ scenarios. Risk models allow investors to calculate the impact
of changes in economic variables, and ensure that bottom-up portfolios are
aligned with top-down views. For example, if you are concerned about increasing
oil prices you want to ensure that your portfolio doesn’t have a hidden
Of course, many other trends have popped up in
response to the heightened levels of risk experienced over the past five years.
The current risk environment appears to be relatively benign, as volatility in
most markets remains low and correlations within and across asset classes have
returned to more ‘normal’ levels, allowing assets and asset classes once again
to obtain diversification benefits.
However, the memory of the
pain that was inflicted by the global financial and European debt crises
remains and investors want to make sure they can minimise such damage in the
future. The crises helped fuel the growth of risk management tools – and these
tools are here to stay, as more asset owners and managers recognise the
benefits they bring to the process of managing investments.
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