Consultants and pension fund executives across the globe are putting more emphasis and focus on stress and scenario testing of portfolios following a year of geopolitical surprises and all-time highs in markets.
While stress and scenario testing has been present since the fallout of the financial crisis, sources say shocks in 2016 — such as the U.K.'s vote to leave the European Union and the election of Donald Trump as U.S. president — have been a catalyst to put increased weight on the outcomes of these tests.
It is not so much an increase in the frequency of stress testing, “but putting more focus on the actual outcomes or projected outcomes,” said Matt Maleri, partner, asset allocation at Rocaton Investment Advisors LLC, Norwalk, Conn.
While the worst outcomes were easier to dismiss in the past, Mr. Maleri said they now receive attention. Outcomes often are “getting elevated to committee level, board level discussions, whereas years past it was perhaps just a discussion among staff at Rocaton. We have learned that the so-called one-in-100-year event seems to happen more frequently — we don't find that surprising at all,” he said.
All-time highs in markets also help to heighten awareness of what can go wrong, he added.
Some countries' regulators encourage periodic stress and scenario testing. The U.K. Pensions Regulator's DB code of practice encourages trustees to use a variety of qualitative and quantitative approaches to risk management, such as stress and scenario testing. In the U.S., the Office of Financial Research said in relation to risks in non-financial corporate credit that broader stress testing could reduce financial stability risks. “At a minimum, regulators could require stress tests of the largest exposed groups of firms,” including pension funds, said its 2016 Financial Stability Report. The European Insurance and Occupational Pensions Authority also conducted a Europe-wide test in 2015.
“We would have said it is best practice anyway,” said Alasdair Macdonald, U.K. head of advisory portfolio management at Willis Towers Watson in London. “It is not always the case that regulators are pushing a best practice open door, but this is a case where the regulatory imperative aligns with best practice and with where we are in markets: the world is changing. To the extent that past performance is not a great guide to the future, and models derived from past performance, we do have to rely more on stress testing or scenario modeling.”
While stress and scenario testing is not necessarily new to consultants and pension fund executives, the developments of 2016 have shifted the goal posts in terms of how they are conducted.
In the past, these tests have been driven by a specific event such as the technology boom or the Asian financial crisis. “It tended to be one thing at a time, (and clients) wanted to see stress against this crisis or that crisis,” said Edmund Walsh, director at Meketa Investment Group in London. “But as we are coming into this "new normal,' it is going to be particularly important trying to think about how to handle those different types and variety of risks. There is an increase in the sheer number of (risks), but also the interconnectedness of those — how they play off against one another, and how (to) deal with multiple crises.”
Meketa has been investing in technology and big data, incorporating machine learning into its work to understand the interconnections of risks. “The only way to get these complex, multifaceted moving parts was to really scale up the type of analysis we were doing,” he said.