With central banks moving into negative interest rates, UBS Australia and New Zealand head of investment strategies Tracey McNaughton thinks advisers and portfolio managers need to consider ways to manage the new types of risk facing investors today and in the future.
In a recent Netwealth webinar, McNaughton - who has nearly 20 years of experience in the investment industry - discussed why she believes it is time to rethink how we approach risk management.
The session was a part of Netwealth’s monthly educational program designed to give advisers a clearer perspective on the challenges facing their businesses, and their clients’ financial success.
Close to the zero line
During the broadcast McNaughton described the current global economic outlook and the reasons why there need to be significant changes made to global investment strategies, as central banks move from zero interest rate policy (ZIRP) to negative interest rate policy (NIRP).
McNaughton said: “China is continuing to slow, and the world is still in love with debt – the total stock of non-financial government debt is up more than $50 trillion since the GFC We're also beginning to appreciate the quantitative limits of quantitative easing. Japan is running out of government bonds to buy, Europe is still not out of intensive care, and the US is struggling to generate a self-sustaining recovery. Historical correlations can no longer be as relied upon as they once were.”
She added that the RBA recently stated that the average return on savings, “at least for a protracted period, will be lower than previously.” In this lower-for-longer environment, driven by global economic structural change – ageing populations, excess capacity following the GFC, less leverage in the banking sector – asset managers require a much more sophisticated approach to managing risk. “We’re now closer to the zero line, so the focus on risk management has necessarily increased, to the point where managers need to focus just as much on risk as return,” she explained.
New types of risk
And risk is now coming from unexpected places: investors’ search for yield over the past decade has put pressure on bond yields, which were, McNaughton continued, “traditionally a cushion that would offset against capital losses in the bonds.” At this stage, though, yields only need to rise slightly for investors to have a negative total return. She pointed to the Australian 10-year bond yield, which could produce negative returns if yields were to rise by 30 basis points, “which is a vastly different environment to where we were in the 1990s.”
The rising age of investors has also increased “sequence risk” – that is, they can no longer necessarily afford to ride out volatility in economic cycles, because they have shorter investment horizons. This means benchmarks need to be selected carefully – McNaughton highlighted the rolling 10-year benchmark for global equities, which from December 1989 to December 2013 saw 26 down periods out of 293.
Winning by not losing
The threat of sequence risk has triggered a rise in the use of absolute return funds, and a new philosophy that focuses on “winning by not losing” – placing an emphasis on the gain percentage required to recover from a loss. To do this, managers need to be as “unconstrained from the benchmark as we can,” which involves choosing long and short positions, diversifying across as many different markets and asset classes as possible, prioritising liquidity and reviewing asset allocation on a regular basis. In UBS’s case, McNaughton said, the investment team meets formally “twice a week now, and informally on a daily basis.”
Integrating risk with return
Crucially, there is now a much stronger relationship between risk and investment management. Tail and event risk management are now paramount concerns, which involves protecting against extreme and unpredicted market movements by purchasing protection at the expense of some return, and using scenario analysis and stress testing. “You have to be as diversified across the kind of trade you're doing,” she continued, “as well as diversified across time horizons – individual trades that will come due at different times to avoid cluster risk – and diversified across different instruments: futures and options.”
In order to improve this process, McNaughton said the UBS risk team now “sits beside us, and they help us in things like designing the trade, in things like portfolio construction, optimising the risk and return portfolio and identifying the sources of alpha."
Managers are now also embracing the concept of “risk parity,” which differs significantly from a traditional asset allocation approach. In the case of a traditional 60/40 balanced fund, the majority (90%) of risk comes from equities, with fixed income contributing only 10%. Using risk parity, asset weightings are driven by the extent they contribute to risk, ideally resulting in a more even split and optimising diversification.
“We do this to an extent at UBS where we look at the risk factors we’re happy to take,” McNaughton explained, “and then we think about the best way to capture that risk.”
McNaughton concluded by saying that dramatic changes in markets over the past decade have driven this evolution in risk management: “We have to think with a ‘risk management hat’ on more than ever before.”