In 2008, Rahm Emanuel, then chief of staff to President Barack Obama, said in a remark that has become famous: “You never want a serious crisis to go to waste. What I mean by that (is), it's an opportunity to do things you think you could not do before.”
Pension funds and other asset owners need to think like Mr. Emanuel and steer their investments to perform well in crises. They cannot let adversity go to waste.
The challenge is for them to see adversity as a potential source of return, not only as an opportunity for possible loss.
Asset allocation and investment strategies historically have been focused primarily on performance, driven by the market and economic environments. As the market has risen and fallen, so generally has investment performance.
In bear markets, economic downturns or fundamental adverse changes in investment climate, investors have tended to seek shelter from storms. They've moved to defensive allocations to reduce risk and preserve capital. They have given up potential upside return to reduce risk of loss.
For example, market concerns about the Federal Reserve tapering of its quantitative easing program have left investors with “nowhere to hide other than cash,” Chris Siniakov, managing director and chief investment officer, Asia-Pacific, Deutsche Asset and Wealth Management, Melbourne, Australia, told Pensions & Investments.
Just as the Fed's policy of quantitative easing has contributed to the rise in equity and fixed-income markets, concern about ending the policy has caused U.S., international and emerging markets equities to pull back, leading to declines in indexes for U.S. Treasury securities, commodities and Treasury inflation-protected securities.
Now, even a defensive approach contains great risk in asset performance as rising interest rates cause falls in fixed-income portfolio valuation. Even cash risks underperforming if rising inflation expectations become reality. But rising interest rates help pension funds by reducing the projected benefit obligation, counterbalancing that asset loss and helping achieve funding objectives.
In such turbulence, pension executives must search for new sources of return for growth-seeking assets to help raise funded status.
Funds need to embrace risk and turbulence in the market and economy.
Nassim Nicholas Taleb calls such an idea anti-fragility as in his new book “Anti-fragile: Things That Gain From Disorder.” In an anti-fragile approach, investors are better off from pressure and turmoil.
That kind of thinking calls for investors to do more than rethink defensive strategies and the underpinning of asset allocation; it encourages them to capitalize on decline and better manage risks.
There is a lot of fragility in the economy and markets. Economic growth remains weak, albeit improving. It rose only at an annualized rate of 1.7% in the second quarter, up from the 1.1% rise in the quarter ended March 31. Unemployment remains high although it, too, is improving, at 7.4% in July down from 7.6% in June.
Anti-fragility is more than resilience. It is use of disorder and upheaval to thrive. It is an approach to deal with downward volatility and uncertainty.
Investors often have prospered on creative destruction in the markets, as business and industries give way to newer, better entrants. J.P. Morgan, the banker, epitomized that approach in the quote attributed to him: “Calamity is opportunity.”
Some pension funds and other asset owners have embraced the negative side by using investment strategies that involve short selling as well as allocations to hedge funds.
To deal with stress in the market, they have broadened their diversification, moved to asset allocations based on risk measures or risk budgeting, rather than asset return performance, and adopted leverage in such strategies as risk parity to seek to gain more return from traditionally low-risk assets without increasing volatility. Among other strategies, smart beta approaches, or reweighting indexes to boost systematic return, has attracted investors.
Rather than reduce risk to shelter funds, asset owners need robust enough approaches to capture all risks and manage them to their benefit.
Most asset owners remain captive of favorable market trends. On the liability side, they depend on trends in interest rates, which lately have been favorable in lowering obligations. On the asset side, they are dependent on rising markets. But with so-called anti-fragile approaches asset owners thrive both on the asset and liability side.
Such so-called anti-fragile approaches show asset owners still can succeed in moving to their objectives even in adverse circumstances. n