Rewards via risk: Focus shifts in post-GFC world

Grant Froster

By

13/02/2017

OPINION | The global financial crisis was a defining moment in the history of investing.

The crisis brought one of the worst bear markets of the last 100 years. As markets plummeted, conventional diversification based on asset classes simply didn’t work, at the very time it was needed most.

Once investors had drawn breath and evaluated the devastation, approaches began to change. A focus on controlling risk became the theme, as investors sought new ways of producing returns, via improved asset allocation and investment vehicles. 

Our latest CREATE report: 2008: A turning point in the history of investing seeks to highlight the nature of the evolving investment approaches that have gained momentum since the GFC, to assess their impact and look at their evolution. For the report, CREATE-Research, in conjunction with Principal Global Investors, surveyed chief investment officers of 15 global asset managers and pension plans. The bottom line: 2008 was a reality check.

 

Investment vehicles abound

Post-GFC, the report states, the traditional focus on volatility as the key measure of risk began to be re-evaluated. Risk was being defined more and more by the maximum drawdown investors were willing to tolerate in a given year.

There was a realisation that better returns and better risk control would require improved asset allocation and better investment vehicles. Together, these approaches mark a new chapter in the history of investing.

Investment vehicles have increased exponentially since the GFC, and with them has come a greater focus on new, more specific tools, as well as on different vehicles and asset classes.

Diversification by risk factor, absolute return investing, and the use of alternatives, private equity and hedge funds have all become more prevalent. At the same time, there is now an increasing use of exchange-traded funds (ETFs), smart beta and thematic opportunities. Multi-asset investing, which helps generate portfolios with exposure to a greater range of asset classes, has been the most prevalent trend across all investor segments. And this makes sense; multi-asset investment can provide reasonable risk-adjusted returns through intelligent diversification, which reduces both market and inter-asset class correlation.

Smart or strategic beta funds employ essentially passive strategies that seek to control risk and produce returns by using alternative weighting schemes. These funds weight portfolios according to a range of factors, such as dividends or volatility.

Also part of the smart beta set of strategies are so-called thematic funds, in many cases ETFs, which pursue overt themes in their investment styles. These themes can be demographic or social. They can provide exposure to specific sectors like healthcare or bank restructuring. They can also track the market impact of the spending habits of millennials, for example.

 

Absolute return investing aims to cut downside risk

The traditional view of risk assumes that returns on stocks are entirely driven by systemic market risk. In fact, research shows that other factors, including stock valuation and size, also affect returns. Factor-based diversification seeks to identify these influences to offer greater transparency and control over risk exposures.

Prior to the GFC, the dot.com crash in 2000-02 sparked a desperate search for assets and portfolios with uncorrelated returns. The GFC only heightened this. Post-GFC, many previously uncorrelated asset classes began to move in lockstep, presenting challenges for investment managers seeking diversification.

The CREATE report highlights that one of the enduring legacies of the 2000-02 bear market was the division of portfolios into cores and satellites. By using a range of techniques not available to traditional investment portfolios, such as the ability to go short as well as long, or the use of derivatives to protect the downside, absolute-return strategies aim to produce positive returns regardless of market conditions.

It’s not all upside, though. While absolute-return strategies can enhance opportunities, they may also bring increased operational complexity and historically have lagged rising markets.

 

Still growing in importance

The nature of risk management post GFC has become more complex. The key message from the research is that most investment approaches developed to respond to the crisis are likely to grow in importance through the remainder of the decade.

The big unanswered question is whether these new approaches will continue to perform when monetary policy normalises. These are challenging times for investors. Times that demand smarter ways of investing and better ways of distinguishing value traps from value opportunities. Success is possible, but diligence, patience and good governance are key.

 

Grant Forster is the chief executive of Principal Global Investors Australia.

 




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