Risk Management

Is the world a risky place? Screaming headlines warn about inflation risk in the U.S., deflation risk in Europe, geopolitical risk all over the globe, regulatory risk, liquidity risk, and many other kinds of risk. But over the past several years, as the world has struggled to emerge from the financial crisis, equities have been on a tear. The Fed is still hesitant about raising rates too much, too soon. Inflation is nowhere to be seen, and realized volatility remains dampened. So just how risky is the world right now for different types of investors?

Our panel of experts takes on a wide variety of issues related to risk. They tackle this broad topic from a macro and asset allocation view, as well as from an asset class perspective, covering global fixed income and equity markets. And they agree that, when it comes to a forward-looking appraisal of risk, investors would be ill-advised to remain anchored in the recent past. The world is changing, and in each region and asset class investors are facing new, unique, and challenging kinds of risks. But this group of professionals is intent on helping investors sort the signal from the noise— and get positioned to protect their assets while spotting new opportunity.

Carl Hess: Many market indicators are telling us that we have moved from crisis to complacency. The VIX trading range is quite low compared to three or four years ago. Realized volatility has been low. Depending on your timeframe, you could reach rather different conclusions as to where the world is right now on the issue of risk.

There are two paths that we see as having a decent likelihood. The first is that we continue stumbling along in a low-volatility, low-return, low-growth world. The second is that life gets quite a bit more interesting, caused by a tail risk scenario—perhaps a meltdown in the European periphery, a further growth slowdown in China, a world of $25 or $250 oil, or all of the above.

The market is reflecting a bit of a weighted average between those two views.

Kathleen Gaffney: The word “anchoring” is a good place to start. The Fed has done a great job of anchoring investor expectation in order to bring confidence back to the market. That's what has propelled us through the last six years. The risk is that in remaining anchored, investors aren't open to capitalizing on the opportunities brought by a new environment.

After a 30-year secular decline in interest rates, the risk is we're not going to stay here. Investors need to let go of that anchor and think about what is likely to happen, and how they might protect against those risks. Higher rates impact specific pockets of the fixed income markets. The first is short duration, where a lot of investors are complacently positioned. Coming out of the crisis, they were worried about capital preservation and moved into short-duration products at a very high opportunity cost, because we're at the zero bound. Another group of investors has been chasing yield, which has caused traditional credit markets to become overvalued.

The primary risk to fixed income investors is they see those two benefits dissipate very quickly. Many investors are still heavily committed to these positions based on their experience over the past six years. Unless they start to think about what really lies ahead, they're not protecting themselves against risks that really matter.

Kamilla Svajgl: I agree with Carl that markets are past the crisis mentality and have reached a level of complacency. We all know that 20% annual equity returns with historical low volatility are not sustainable. In fact, over the years, some of the largest down markets occurred after long periods of market growth and low volatility. In times of crisis, individual investors are especially vulnerable to poor decision-making: they often sell out of equity after a decline occurs and move into safer assets. By doing this, they lock in their losses. Numerous studies show that the buying and selling behavior of an average investor reduces individual returns between 1% and 4%.

At the same time, moving out of equity is not a solution. We all know that Americans have not saved up enough for retirement and they need to be able to participate in equity upswings to ensure that they do not run out of money.

Therefore, I believe it's up to the retirement industry to help investors stay invested in equity, while at the same time offering tried and tested risk management strategies that will prevent them from losing their nest egg during the next crisis.

Kamilla Svajgl: Let's start with the way people define asset allocation and risk. It used to be that “risk” was defined by an investor's level of equity allocation. For example, 60% equity/40% bond portfolio was used as a proxy for “moderate risk.” There is a fundamental problem with that — a 60/40 portfolio would have experienced mere 7% volatility in the fourth quarter of 2006, but 67% volatility in the fourth quarter of 2008. I don't think anyone is a moderate risk investor when they're experiencing 67% realized volatility. These kinds of large swings in portfolio risk are not only highly correlated with sharp declines in the market, but also expose investors to significant behavioral risk of selling when asset values are deeply depressed.

A better way to define risk is by portfolio volatility. For a moderate investor, that might mean an overall portfolio volatility of 12%, for example. So the first step is to stabilize volatility. And the good news is that volatility lends itself very well to short-term predictive modeling. Therefore, while I will not be able to tell you if the market will go up or down tomorrow, I can be very accurate in assessing whether it will be calm or volatile.

The second step of the strategy is to add some additional downside protection for extra cushion. We achieve it by synthetically replicating a long-dated put option within the portfolio. This further reduces losses during periods of significant and sustained market decline. This approach has been used by large life insurance companies during 2008 to successfully hedge their balance sheets.

Combining volatility management and capital protection allows investors to stay invested in equity during calm market conditions, and at the same time protects them during times of crisis.

Kathleen Gaffney: The global economy isn't strong enough to withstand a significant rise in interest rates, and currently, inflation is not present. However, central banks, particularly the Fed, need to get off the zero bound. The issue unexpectedly becomes less about a spike in rates and more about the shape of the yield curve, and how the market transitions to normalization. Investors need to take a step back and identify risks in this scenario, as well as how they can position themselves to benefit and generate attractive returns.

When they see potential for higher rates, many bond investors automatically and defensively move into short-duration strategies. If the yield curve is flattening, risk is concentrated at the short end of the curve and may not deliver the returns they anticipated. They likely would be better off taking different types of risks, which is why we have seen an increase in demand for multi-sector bond strategies.

What risks are actually worth taking in the current environment? I would avoid interest rate risk as much as possible right now. And in the structured- and mortgage-finance markets, prepayment risk is still significant. Credit risk, however, is attractive when the yield curve is steep, fundamentals are improving and the economy is recovering. There are many ways to get exposure to credit risk, and we view this as a great lever to pull in this type of transition.

We are also cautiously optimistic about select currency and country risks. Despite near-term strength in the U.S. dollar, we believe in reversion to the mean. The dollar's appreciation cannot continue forever at its recent pace. Higher U.S. interest rates and a strong dollar are potentially creating opportunities away from the U.S. in the developed world as well as emerging markets.

Credit, country and currency risks are all ways to manage risk and generate fixed income returns in this new world away from the zero bound.

Carl Hess: Across most major markets, risk is priced reasonably fairly. Valuations may be a little bit on the expensive side, but not ridiculous. Credit prospects have improved, and, as Kathleen pointed out, that's largely but not fully priced in.

Now, if we see a rise in rates, especially if quicker than expected, we could have sudden market dislocations as investors step away from the current mentality that says low bond yields give me very little, so the only place to put my money is in equities. That thinking would reverse quickly, especially for yield-oriented investors. And that isn't just retirees, but also insurers, pension funds and others who have cash obligations and liabilities to match — who have been sitting on the sidelines.

The growth story remains in the East. Demographics are in their favor. The switch from investment-led to consumption-led growth should also work in their favor. But economically, we are also optimistic about the U.S., although by no means have we solved all our issues — look at broader unemployment measures. One worry is that corporate profit margins will see compression. As a share of GDP, they've climbed to an all-time high, and while reversion is not inevitable, it is certainly possible.

The “sick man” in general seems to be Europe, where demographics haven't caught up to Japan, but they're headed there. While there is a lot of differentiation among countries, there is systemic stress, and it's not clear that a single monetary policy will work for the entire Euro Zone. Whether the center holds or we head to a climactic breakup is the big issue of the day. It's hard to think of investing in the European core as dangerous, but looking at the potential instability, the assumption of safety feels increasingly dubious. So even though Euro Zone equity valuations look relatively attractive, investors need to recognize that some of that is just pricing in that tail risk.

Carl Hess: It's more important for investors to reaffirm their comfort level with the risk they are taking in their portfolios, and the risk position they are aiming for relative to their objectives. We would ask, “Is it worth spending your incremental dollar on derisking, rather than looking for a place to take risk?” It is entirely possible that if growth remains dampened, then the great march toward diversification, which has been the story for the past five years, may not earn you much incremental reward in a world where all risk premia are priced tightly. So doing well with what you have might be far more important than trying to access every asset opportunity under the sun.

Kamilla Svajgl: Diversification is a wonderful tool, and under most market conditions it reduces risk and improves returns. However, it doesn't help in crises when all assets decline together. Diversification doesn't equal derisking as markets become more correlated. There are three main risks that investors face as they near retirement — market risk, inflation risk and longevity risk. These three risks give rise to the main question that the average retirement investor is trying to answer: how do I minimize the probability of a scenario where I run out of money in retirement? Given that most Americans have not saved enough for a comfortable retirement, they must depend on capturing equity returns to boost portfolio value. Their challenge is to be invested in equity during calm market conditions, while employing an active “derisking” strategy as volatility in the market spikes up.

Kamilla Svajgl: The type of strategy I am discussing has been used by the life insurance industry for years. In addition, universities and institutes, farmers and meatpackers, and many other industries have been implementing risk mitigation strategies using derivatives for decades, even though they are not traditionally thought of as being on the forefront of financial innovation. It should be very straightforward for the retirement industry to implement these sophisticated risk management strategies by simply making mutual funds with these strategies available within DC plans. These funds are available and are out there for DC plans to use. Just like the retirement industry adopted target-date funds in the 1990's as first-generation risk management strategies, it can now do the same with the risk-managed funds.

Kathleen Gaffney: Investors have always thought of core fixed income as a safe haven. However, market risk today is concentrated in that core allocation, holding the potential for negative return as rates move higher. To de-risk, investors need to think differently about that core positioning as being a safe haven.

There is also a bit of a conundrum because once rates go higher, many believe these concerns will go away. But during the transition period, any deterioration in their fixed income portfolios may leave investors unable to meet their objectives, if they don't de-risk appropriately.

That may mean smaller allocations to core fixed income, or a more conservative strategy with an emphasis on taking risk only where they're going to generate more return. A simple way to do that in a rising rate environment is with a laddered strategy. A portion of the allocation will meet income needs, but another portion would allow the investor to take advantage of risks worth taking.

In today's market, credit opportunities are likely to be in a variety of different forms. While the investment-grade and high-yield sectors might be overvalued today in general, investors can tap into different areas within those markets, focusing on convertible bonds, or floating-rate notes, or non-U.S. bonds, in both U.S. dollars and local currencies. We see a wide variety of opportunities around the globe in country and currency risk, as the global economy adjusts to rising rates.

Some investors are replacing traditional core portfolios with liability matching — an expensive proposition in today's low rate environment, but at least it's a known expense. Beyond that investors can allocate funds to higher returning strategies like unconstrained bond strategies. It's a barbell approach where after de-risking, investors can build in room for total return potential — a very different approach compared to the last several decades, when fixed income was seen more as a safe haven.

With this changing mix between traditional core and more flexible fixed income, it's important for investors to take into account increased liquidity risk, which I don't think is properly priced by the market currently.

Kathleen Gaffney: Liquidity fears are front and center. New regulations are aimed at preventing a repeat of a leverage-driven financial crisis. Market makers are constrained in their ability to leverage balance sheets and smooth out markets. Without these intermediaries, it can be tougher to match buyers and sellers.

What we saw in 2014 with higher volatility were larger price gaps, with sellers not finding enough buyers. Investors are not prepared for the mark-to-market impacts. While there may be less leverage in the market compared to 2007, we could see very big market disruptions, given the reduction in market makers' liquidity.

One approach is to have significant cash, which is always liquid. Liquidity events tend to be short lived. The best way to avoid liquidity risk is to stay put — if you don't have to get out of the market.

Carl Hess: Start with the basics: is your objective actually achievable? Most institutional objectives and return assumptions were set at some point in the past, when times were very different.

Today, inflation expectations are far closer to zero than they are to five. The market is trading at three times the price level it did back in the 1920s. And bond yields are a fraction of what they were 25 years ago. You need to unwind all that appreciation out of your future return expectations, rather than just say, historical returns are what we'll have going forward. If you're assuming a continuation of the past, you are saying a market that has gone from a PE of 8 to 24 will now go from 24 to 72, and I'm not sure that would be my default view of the world.

Carl Hess: Complacency could prove very costly, particularly around regulation and the proper functioning of markets. We all want well-regulated markets that tamp out the abusive behaviors that seem to pop up from time to time. But regulation can stifle as much as it can create.

We do have to worry that some of the constructs that have been brought to life with recent financial re-regulation, and some of the institutions operating in the markets — for example, clearinghouses — are relatively untested. We don't know whether they will be able to handle extreme market dislocations.

And just as governments are a huge player in the system, so are all our fellow investors. The feedback loops in the system are faster and more immediate, which drives increased systemic volatility. That is here to stay, and this oscillation is going to keep growing.

Carl Hess: We need to inject a bit of long-termism back into the system. Our industry is somewhat guilty in that regard. In the retirement industry, for example, daily trading, liquidity and valuations serve very few people's long-term interests. All it does is facilitate very hasty and often very poor decision-making.

I would suggest that people spend more time thinking about the risk they haven't thought about yet. Keep an open mind. Don't anchor on where you've been. Think about where you're going and what it's going to take to get you there.

Kathleen Gaffney: One thing on the macro side I think is important is geopolitical risk. The 2008 global financial crisis taught us that when growth is not available, politics trump everything. That was a new type of risk that hit our radar screens coming out of the global financial crisis — i.e., how important politics have become as a factor in the investment decision-making process.

I see an environment where developed markets have learned how to deal with crises. Not too long ago, we went through a big one. It's pretty clear the U.S. is coming out of it, with Europe and Japan hopefully to follow. But emerging markets like China, Brazil and Russia are really struggling to produce growth in this new environment. While emerging markets are expected to become a bigger part of the global economy, there could be political risk to that growth, which isn't fully priced in markets today.

Investors should stick to their long-term plan. Block out the day-to-day noise, as that will only make you second-guess yourself. Always question what the consensus is missing. That's where the best returns and values will be found.

Kamilla Svajgl: Investors need to be honest with themselves in terms of what their risks and objectives are. In retirement, the problem they are trying to solve is, “How do I provide for myself and my family when I no longer work?” The solution should be tailored to this problem, and they need to be open minded in terms of risk mitigation strategies that are available in the market.

However, I also don't think it's quite fair to expect individual investors to be risk management specialists. But in many cases, that's what we're asking them to be, and few of them are succeeding at it.

The big picture for 2015 should be for the retirement industry to adopt well-established risk management techniques that have been widely used by other industries for decades. This may offer substantial help to investors in achieving their objective of sustainable retirement income.