Investors are unprepared for next financial crisis

Five years after the collapse of Lehman Brothers Holdings Inc. sparked a global markets meltdown, institutional investors have a better handle on risk in their portfolios, but aren't necessarily better prepared for the next “black swan.”

See sidebar: Lessons from Lehman, the global financial crisis

Institutional investors are paying more attention to liquidity, boosting the sophistication of their risk oversight and experimenting with approaches that adjust allocations in response to changes in that risk landscape. Even so, such efforts may prove only incrementally helpful when the next market calamity — inevitably different from the previous one — occurs, many investors say.

At the height of the global financial crisis in late 2008, Richard M. Ennis, then editor of the Financial Analysts Journal, called for “innovative thinking” to help the global investment community better cope with “volatile and unpredictable” financial markets.

Five years later, market veterans say progress toward that goal has been tentative at best.

“The most shocking thing five years on is how little the world has changed,” noted Robert D. Arnott, chairman of Newport Beach, Calif.-based money manager Research Affiliates LLC.

Market participants are more alert to risks now than before, but it's hard to argue they'll be any more prepared when the next crisis strikes, Mr. Arnott said.

With the crisis cementing the status of liquidity as a legitimate asset class, and liquidity's huge value premium during financial upheavals, “you would expect more resiliency” for institutional portfolios today, said Mark Anson, Menlo Park, Calif.-based chief investment officer of Acadia Investment Management — the Bass family office launched in April.

Instead, the current low-interest-rate environment has seen “many institutions jump with both feet into high yield, real estate, distressed debt — anywhere they can get some yield above U.S. Treasuries — and this puts them at risk even more for another crisis,” Mr. Anson said.

Meanwhile, most of those interviewed said it's too early to talk about the end of the last crisis when investors are still grappling with the impact of unprecedented central bank monetary stimulus aimed at returning the U.S. and European economies to a sustainable growth path. So far, that stimulus has resulted in asset inflation, rather than economic inflation, and “this has to reverse at some point,” said Mr. Anson.

That's not to say that nothing has changed over the past five years when it comes to managing institutional portfolios.

A growing number of investors are adding the analytic firepower needed to better understand the risks inherent in their own portfolios.

Michael Trotsky, executive director and CIO of the $54 billion Massachusetts Pension Reserves Investment Management Board, Boston, said when he took the helm at PRIM in 2011, his investment team lacked the tools needed to easily crunch details about the state fund's portfolio, such as its exposure to European markets or the duration of its bond portfolio.

The addition of MSCI's BarraOne risk management system last year has allowed PRIM's team to give its board a detailed picture of “what kind of portfolio we have,” and to do scenario analyses of how it should behave under various conditions, noted Mr. Trotsky.

It has likewise helped PRIM “determine what our managers are doing,” and make better asset allocation decisions, he said.

Meanwhile, the U.S. endowment funds that pioneered big allocations to hedge funds, private equity and real assets — moves pension funds and sovereign wealth funds adopted in droves over the past decade — have adjusted their portfolios in search of greater flexibility, even if their allocations to alternatives have continued to edge higher.

Since 2008, big endowments, led by Harvard and Yale universities, have more than doubled (to 3%) their average allocations to cash, while boosting the portion of direct or co-investments in their private equity and real estate allocations to minimize long-term lockups, noted Keith Black, director of curriculum with the Amherst, Mass.-based Chartered Alternative Investment Analyst Association. (In 2008, both Harvard and Yale had negative cash positions.)

As could be expected after a market cataclysm on the scale of the global financial crisis, the way institutional investors think about and deal with risk has been the area of greatest change.

There's been a “recognition that the ways (investors) thought about risk in the past were simplistic, and not really representative of the exposure to loss that they had in their portfolios,” said Mark Kritzman, CEO of Boston-based Windham Capital Management LLC.

For example, the crisis helped disabuse investors' faith that the correlation coefficients used to determine appropriate asset class allocations would hold steady at times of extreme market turbulence, Mr. Kritzman said.

When it comes to the tendency of correlations to go to one in a market crisis, “we have all learned a lot,” said Andrew Sawyer, chief investment officer of the $11.4 billion Maine Public Employees Retirement System, Augusta.

That highly sought-after diversification “seems to work when you don't want it to (when stocks are going up) and doesn't work when you want it to,” he noted.

Some market veterans describe that evolution of institutional investors' mindsets over the past five years in terms of becoming more “market aware.”

To a much greater extent than before Lehman's collapse, institutional investors are “trying to figure out what markets are giving you in terms of opportunity and risk, and trying to manage that,” said Andrew Kirton, global CIO-investments, with Mercer in London.

That, in turn, is promoting a more dynamic approach to asset allocation, as investors anticipate opportunities along with volatility, and work to grasp those opportunities more effectively, he said.

Mr. Anson agreed, saying a growing number of institutional investors are “allocating portfolios across macroeconomic drivers: growth, inflation hedge, liquidity and income,” with a much greater willingness to dynamically allocate across traditional asset classes.

If that's a global trend, it might be especially pronounced in the Asia-Pacific region.

David Iverson, head of asset allocation for the NZ$23 billion (US$18 billion) New Zealand Superannuation Fund, Auckland, said the “strategic tilting” program his fund introduced three years ago has been focused on taking advantage of such market opportunities.

That's in line with a growing trend in Australia as well, where more than half of the big funds in that country's A$1.6 trillion (US$1.4 trillion) superannuation fund industry make asset allocation adjustments in response to market valuations, he said.

David Neal, CIO of Australia's A$85.2 billion Future Fund, Melbourne, said his team employs a risk-factor approach to determine asset class targets, but isn't wedded to those targets. If the team's views change with regard to the best risk-adjusted return opportunities the market is offering, “we change our mind,” he said.

Mr. Kritzman said such approaches make more sense than setting rigid asset allocation targets. Investors want as steady a tradeoff between risk and return as possible, while the risk profile of a portfolio with fixed target allocations for various asset segments can vary wildly over time, he noted.

He pointed to Windham's “absorption ratio” — a measure of whether the variability of returns for a number of asset classes can be explained by a few risk factors or a larger number of factors — as part of a second generation of indicators of “turbulence,” or market fragility. When a small number of factors can explain the variability of returns for a large number of asset classes, the market is susceptible to broad sell-offs — a signal that investors should consider reducing risk, Mr. Kritzman said.

Mr. Kritzman said measures of turbulence and volatility can help institutional investors make their portfolios more resilient in market crises, but investors are just beginning to manage their portfolios this way.

New Zealand Superannuation's Mr. Iverson said a number of institutional investors appear to be putting their toes in the water, but it remains a learning process, as factors such as how to explain the strategy to one's board, how to report performance, etc., are worked out.

Some observers insist the painful lessons learned from the global crisis will pay dividends, even if they are incremental ones.

“We have in no way eliminated the risks of a market crisis, but are we, over time, marginally becoming better equipped to deal with that? I think the answer is yes,” said Bo Kratz, Northern Trust Corp.'s Hong Kong-based managing director for asset management in the Asia-Pacific region.

Others are non-committal: It's hard to tell if institutional portfolios will prove more resilient, since “none of the new approaches have had a midlife crisis yet,” noted Amin Rajan, chief executive of London-based CREATE Research.

More, however, are unwilling to predict that the changes institutional investors have made over the past five years will make their portfolios significantly more resilient during the next financial crisis.

“Most of us still have 90% of our risk allocated to equity risk,” leaving little reason to expect a much better outcome next time, said Maine's Mr. Sawyer.

Research Affiliates' Mr. Arnott sees reasons to be downright pessimistic. In the area of broader risks, “too big to fail” remains a bigger problem today than it was before, he said. And the proposition that risk can be modeled with sufficient detail and accuracy to insulate portfolios should, as in the past, prove a “false comfort,” he warned.

See sidebar: Lessons from Lehman, the global financial crisis