Managing risk in a very challenging economic environment (s)

Experts:         Jon Mawby, Pictet asset
Facilitator:    Roderic Rennison, Rennison Consulting Ltd

State of play

• The pandemic means we are now living through one of the most challenging risk environments we have ever known. 
• The FCA is keen to see advisers take a broader view of Attitude to Risk (ATR). They are keen to see the risks to clients’ expectations not being achieved being addressed as well as the risks involved in the investment propositions being advised. 
• Investors on average give up 3% of returns for behavioural reasons in their pursuit of in-the-moment emotional comfort. 
• Some advisers are adjusting their ATR methods by reframing the risk around the achievability of goals. This allows for a much better conversation about objectives rather than market volatility. 
• The current volatile business environment has made it more difficult than before for risk management capabilities to keep up. The new environment provides strong incentives for financial institutions to transform how they manage risk to become substantially more effective and efficient.
• This will require institutions to seize opportunities related to strategy, people, the three lines of defence model *, and technology in a coordinated way.

* The Three Lines of Defence (3LOD) Model is a systematic framework used in dealing with threats and risks. It is adapted by countless organisations and institutions of varying nature around the globe. For years, it has guided countless decision-makers and managers to manage risks effectively for the benefit of their respective organisations. 

• Institutions will need to embrace emerging technologies — such as robotics process automation, artificial/cognitive intelligence, natural language processing, and machine learning — that can reduce costs, while also offering foresight into emerging risk issues. 

Jon Mawby’s main points

Post Global Financial Crisis things have changed…

• The traditional starting point for asset allocators of 60% equity and 40% bonds is misguided
• It is built around global government bonds being 3 things:
  • A store of value
  • Having a reasonable yield
  • Lower or negative correlation to risk assets
• At sub-1% 10-year yields, we believe government bonds now have a very limited upside and potentially very large downside
• Hence one cannot rely on the traditional model to produce the same risk return characteristics going forward as they have for the past 30-40 years
• This applies both generally to risk asset portfolios and more specifically to credit and fixed income products

Proposed Solution 

• A CONTRARIAN and VALUE driven approach is vital to protect capital and produce reasonable risk-adjusted returns taking advantage of volatility and not being captive to it
• Global government bonds are now more a trading instrument than a long-term investment
• This leaves investors with essentially two traditional choices in terms of long-term asset allocation
  • Equity-like risk (credit, equities, private equity)
  • Cash
• Hence portfolios are by design riskier than historical models will predict
• Going forward, more innovative (but still simple) methods need to be used to produce a credit portfolio that has lower correlation to risk assets

Points discussed

1. Q: Isn’t it more cost effective to use an ETF than an actively managed fund in today’s environment?  A: Actively managed funds allow you to manage risks more specifically; the lower level of bps on passive funds is not necessarily a real saving as there may be greater volatility.
2. Q: When you say that you focus on liquidity, what exactly do you mean?A: There is a need to stay highly liquid to be flexible and nimble. Liquidity is key. We like to be able to “mark” all the elements in a portfolio daily.
3. Q: Value Investing: has it had its day after 10 years being out of fashion?A: No. 
4. Q: How do you manage client expectations?
5. A: By being clear in communicating with clients and being disciplined.
6. Q: Have you, or would you position the fund net short duration overall?A: Not to date, but the situation may change – for example as a result of the US election and/or an inflationary environment.
7. Q: Is risk misconceived? Are fixed interest investments actually riskier than equities?A: Yes, based on some measures; for example, both liquidity and credit risk have increased.
8. Q: What is the impact of ESG?A: Good governance has always been important, and we were managing funds to the standards highlighted by ESG long before it became prominent.

Conclusion

• Times have changed in fixed income
• Central bank and investor actions have distorted the playing field
• Downside risks have increased, and mis-pricings are commonplace
• Traditional fixed income strategies are very unlikely to deliver what investors need from their allocation 
• An unconstrained, opportunistic approach with no underlying cognitive bias and the discipline to wait for the right entry point is the correct way to navigate the cycle
• Combine a value-driven stance, contrarian mindset and dose of common sense, to provide investors a bond allocation that aims to:
  • Diversify and give a very low correlation to risk assets 
  • Reduce capital losses in times of stress
  • Provide some income where it makes sense to do so