The investment community is developing a strong aversion to risk at the institutional levels — with serious consequences.
At the heart of the issue is that investors seem to be confusing volatility with risk. Volatility consists of short-term losses and the day-to-day ups and downs of the market. Real risk, on the other hand, is not having enough on which to retire, an issue that affects pension fund managers who will not be able to meet long-term financial obligations to their members.
The problem is many investors find it difficult to tolerate volatility. Because of this, over the past few years, investment managers (whether of 401(k)s, individual retirement accounts or pension funds) have begun to focus almost exclusively on controlling the downside, favoring diversified and passive strategies that are completely loss and risk averse.
This approach can engender serious biases hampering a manager's decision-making abilities, such as criticism avoidance and “action bias,” or doing something merely for the sake of looking busy and keeping up appearances. It also has the potential to jeopardize the viability of a strategy's future, in four key ways.
Complexity: While diversification might assume the guise of control, it ultimately makes asset allocation more complex, hurting long-term obligations. In a study titled “Back to the Future,” Robert M. Maynard, chief investment officer of the Idaho Public Employee Retirement System, Boise, found that diversification strategies did not perform better than a simpler asset allocation approach with appropriate rebalancing. In fact, their innate complexity “can lead to complications that threaten any long-term plan when temporary, and inevitable, underperformance periods arise.”
Herding: As more managers adopt the same passive strategies, herding — or highly correlated activity — can create serious problems down the road. In a speech delivered this past April, Andrew Haldane, who is now chief economist and executive director of monetary analysis and statistics at the Bank of England, argued that herding “amplifies pro-cyclical swings in the financial system and wider economy.” The more people latch onto passive strategies, the greater the likelihood of market bubbles, systemic risk and large market swings.
De-equitization: To keep volatility as low as possible, strategies invariably move away from equities and instead turn to lower-duration fixed-income securities like government bonds, making it difficult to pay off long-term obligations. As Mr. Haldane noted, this is a serious issue for the economy because equity is “better able to support the financing of long-term investment projects.”
Lack of capital allocation: Lastly, this focus on controlling the downside deprives investment managers of the very service they're paid to provide: allocating capital efficiently. If everyone pursues beta (market returns) at the expense of alpha (market-beating returns), capital will not be put to work in a way that boosts the global economy and improves our well-being.
It's clear, then, that an approach focusing only on low-volatility strategies can be highly problematic. Strategies focused solely on limiting the downside ultimately limit upside potential. Most importantly, they upend the very principles that define what investment management, retail and institutional alike, is all about.
Instead of avoiding risk entirely, we should be figuring out ways to benefit from it. This mandate has never been more critical than now, with an unprecedented number of American workers on the precipice of retirement and living longer than ever.
So what's the solution? For an investment manager to both pursue alpha and fully execute his or her fiduciary responsibility, a twofold approach is needed. The first is to deliver on current payouts, which a diversified and passive strategy may support. The second is to deliver on long-term obligations, and this should largely come from exposure to equities — the only true generators of new wealth. Best of all, there are strong methods to manage risk associated with equities, such as diversification through global stock selection and the curtailment of long-term risk by investing in undervalued stocks with good balance sheets.
At the end of the day, investment managers are paid to work with and manage risk. That responsibility entails securing positive long-term results as much as weathering short-term volatility. By all means pursue low-volatility strategies for short-term requirements, but embrace risk and equities to deliver on long-term obligations. n
Charles Brandes is the founder and chairman of Brandes Investment Partners LP, San Diego. Robert M. Maynard, who is mentioned in the commentary, is an advisory board member of the firm's Brandes Institute, focused on ideas and research seeking to expand understanding of market behavior and portfolio management.
