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A glass half-empty

In late August, Wall Street’s bull run became the longest in US post-war history, but few investors were cheering.

Among the weariest investors are pension funds. Obliged to meet challenging return targets, yet allowed little flexibility by regulators, they are operating under 20th century constraints while facing wholly unprecedented 21st century market conditions. As the current investment cycle grows long in the tooth and volatility rises, this tension will require a comprehensive re-assessment of risk management. What worked in the past may no longer do so in the future.

Rebalancing is not just a matter of thinking about the overall amount invested in an asset class, but acknowledging that even similar asset classes can carry very different risk levels. So while investors can add value by rotating between assets over time, they need to be just as aware of the changing risk dynamics.

In a low-yield world, the premium on income obscures returns

The search for higher returns has defined markets for years, not least for pension funds, whose heavy liabilities only rose further as yields fell.

Regulatory requirements often force pension funds to reduce risk when they record excess returns, or to increase defensiveness when they are underfunded, which makes it even harder to meet long-term return targets.

The risks you didn’t know you were taking

When all the major central banks were engaging in quantitative easing, investors benefitted from asset prices rising across the board, even as that led to lower yields. Low levels of volatility allowed access to higher-risk asset classes without their typical variability in return. As a result, many investors may well have more risk in their portfolios than they realise, and much of this risk is hidden when using recent history to measure it.

At this stage in the investment cycle for example, with US equity prices at historic highs, many investors would normally be reducing the equity component of their portfolios. But when bond yields are low and corporate profits high, this does not make sense; the more rational choice has seemed to be to maintain risk exposure.

At the moment, any fund that tracks a typical world equity index will be 60 per cent weighted to the US. This is because much of the world’s capital is tied up in Facebook, Amazon, Apple, Microsoft and Google. The result is that many equity allocations are not just heavily US-weighted, but also have considerable concentrated exposure to the technology sector. This bias is amplified by the growing popularity of passive funds, which replicate the index and, by virtue of their construction, allocate increasing flows to any stocks whose prices rise faster than the index, as their proportion of the index grows.

Source: Fidelity International,, September 2018.

What’s worse, minimum-volatility quant strategies have added to these inflows. In 2017, they pushed the collective realised volatility for the FAAMG stocks (Facebook, Apple, Amazon, Microsoft and Google) much closer to that of staples and healthcare shares, the classic safety stocks. The flows in to these stocks pushed their valuations to such an extent that buyers who were originally looking for safer, low-volatility stocks may in fact be holding high-risk assets.

FAAMG stocks are: Facebook, Amazon, Apple, Microsoft, Google. Six-month realised volatility. Source: Thomson Reuters, Fidelity International, September 2017.

Strong dividend-paying stocks tell a similar story. Their attractive income streams have made them so popular that their prices have become elevated and they may no longer be the safe havens they used to be: these investments could turn very sour.

Other types of hidden bias may also be at work. Many investors have a domestic market bias, because they feel more confident when investing at home or because they need income streams in local currency. When volatility rises, this bias can work against them because they are less diversified.

Diversifying into foreign assets, however, creates currency exposure. This is a particular problem for pension funds and insurance groups that have to pay obligations in their local currency. Traditionally, this issue has been solved by taking out a currency hedge like an interest rate swap, but this has become expensive in low-rate markets like Europe and Japan. For example, a European investor seeking to hedge against US exposure is likely to pay upwards of 2.4 per cent for the hedge – which wipes out most of the difference between the current Euro Libor rate of -0.4 per cent and the Federal Reserve’s benchmark rate of close to 2.25 per cent. This is compounding the problems of investors with significant exposure to US markets. With returns so low on many portfolios, high hedging costs eat into returns, leaving investors with a difficult choice between currency risk, hedging costs or a home market bias. Some currency risk may be the best of these difficult options.

Source: Bloomberg, Fidelity International, September 2018.

In addition, risk tolerance varies widely. Investors in emerging markets typically have more appetite for risk than those in advanced economies; young people at the start of their careers can afford to be more risk tolerant than their parents. History is also important. Past performance tends to drive the targets given to institutional investors. It also shapes regulation.

For example, in Germany, pension fund management companies and insurance groups are obliged by law to guarantee a minimum return on certain savings products – a particularly challenging requirement with today’s negative real interest rates. The problem for German asset managers, as for so many others around the globe, is how to live up to the expectations generated by historical returns, when current conditions differ so much from the past.

No more solace from central banks

The US Federal Reserve is now draining liquidity from markets, the Bank of England has started raising interest rates and the European Central Bank is ending its monetary easing in 2019. This post-quantitative easing (QE) world plunges us into the unknown. Correlations (or lack of correlation) that worked in the past may turn out to offer false comfort.

Indeed, even without a market spasm, this is an unfamiliar world: the end of QE does not mean interest rates will return to levels any investor over the age of 30 would recognise. That means there is no prospect of significantly higher yields that would ease pension funds’ balance sheet pressures. Normalisation of cash rates is expected to be slow and the yield from traditional safe-haven assets low. Returns are worse than they were and are unlikely to improve.

This reflects a subset of the propriety capital market assumptions of Fidelity International, as of Q1 2018. This analysis is for illustrative purposes only and is conducted in USD. 2017 USD returns, indices used: MSCI Emerging Markets, MSCI World, Bloomberg Barclays Global HY TR, Bloomberg Barclays Global Agg Corp bonds TR, Bloomberg Barclays global Agg Treasuries TR Source: Bloomberg, Fidelity International, September 2018.

A decade of quantitative easing and low or negative real interest rates has pushed aggregate debt to record levels, posing a particular dilemma for central banks: higher interest rates could make that elevated debt burden unsustainable, leading to slowing growth or even a recession. But if they don’t normalise rates, central bankers could be held responsible for the next bubble in capital markets.

This translates into unusual market behaviours. One example is positive correlations between corporate bond and equity prices that have emerged this year. These matter less when all markets are rising, but when the direction becomes unclear and effective diversification turns from a luxury to a necessity, they leave investors with fewer options to pursue.

Positive correlations may well come to characterise the end of the current bull market; bond market valuations are expensive and yield spreads near historical lows. When equity markets turn, highly valued bonds may no longer look as safe as they did.

This is a subset of 10 per cent+ S&P drawdowns since 2011 using the S&P 500 Composite Price Index and corresponding changes in 10y UST redemption yields. Source: Thomson Reuters, Fidelity International, September 2018.

For pension funds, this mix of rising volatility, low returns, and unpredictable market behaviours is a difficult combination to manage, given that their constraints have not changed, and are unlikely to do so. Challenging return targets remain common across the industry, and funding levels are often low or worsening. The upshot is that investors, and particularly pension fund investors, may not be able to rely on historical patterns or defensive strategies that worked in the past - just when they may need them most.

Chart 6: To meet return targets, investors have moved the risk spectrum

Going up the risk spectrumSource: Fidelity International, September 2018.

Rethinking risk

If the outlook is for higher risk with lower returns and less predictability, investors are left with some quite unpalatable choices. They can either reduce risk and accept lower returns, almost certainly missing return targets. Or, they can accept higher risk levels and hope for higher returns. But not before working out the exact nature of these risks and whether they are acceptable.

So risk has become fluid and unpredictable. In this context, understanding and managing the dynamic risk in a portfolio becomes much more important. A first step is to uncover the hidden risks and unintended exposures of existing investments. Then neutralise these exposures and maximise returns with a strategy based on investment goals, and levels of understanding of and tolerance for risk.

It may then also be useful to reconsider the contribution of risk from individual assets or asset classes. These can differ substantially from their weighting by value. Emerging market sovereign debt, for example, may account for only a fraction of the global value of a portfolio but the lion’s share of the value at risk.

Different risk management strategies can help with different objectives, including anchoring the portfolio’s overall risk level to a specified target, reducing volatility to within certain parameters, or maintaining steady returns.

Targeting risk

One way to keep a portfolio actively aligned with a desired risk profile is a dynamic equal risk strategy. This approach seeks to neutralise hidden biases, such as a preference for the home market, and can help avoid a gradual creep in risk for certain assets. It can be applied to any portfolio profile – defensive, yield or growth. The portfolio’s capital allocation is actively managed to constantly redistribute risk equally across asset groups. As the volatility of individual asset classes changes, their allocation is recalibrated to keep the risk balance unchanged.

This allows the investor to target a specific level of risk more consistently, adjusting for market movements without the need to reconsider the portfolio’s full asset allocation strategy. When market volatility is low, allocations to higher-risk asset classes will probably rise, but when volatility picks up and the market’s appetite for risk wanes, the portfolio will automatically tilt towards more defensive allocations to reduce the risk contribution from higher-risk asset classes. And if any particular asset class comes under duress, its share would be reduced to bring its contribution to the portfolio’s overall risk back to target.

Chart 7: Distributing risk equally across asset groups

Distributing riskIndividual asset class volatilities change, but each exposure is monitored by maintaining equal risk contribution across asset classes. This is a simulated exercise based on our proprietary modelling for illustration purposes only. Source: Fidelity International, September 2018.

Targeting volatility

In the same way, an investor may choose to keep the volatility of a portfolio within a band. When individual asset classes become more volatile, the allocation may have to tilt towards more defensive, less volatile assets such as government bonds and away from groth assets like equities. As volatility subsides, the mix can be tilted back towards more volatile growth assets.

Chart 8: Volatility targeting - Allocating between asset groups on the basis of risk

Volatility targetingThis is a simulated exercise for a diversified growth fund based on our proprietary modelling for illustration purposes only. The portfolio composition in the fund may vary. Source: Fidelity International, September 2018.

Targeting returns

A third approach is to target returns. Investors, such as insurers, often have absolute return targets that must be met. In this context, devising an investment strategy with the goal of keeping expected returns constant can make sense. So as relative prices, volatility and other variables change over time, the return targeting strategy will adapt its asset allocation to hold expected returns constant. It’s like cruise control on a car, targeting the same return by taking more risk when returns are difficult to come by - going uphill - and less when interest rates are higher - going downhill.

Chart 9: Allocating between asset groups to hold portfolio expected returns constant

Allocating between asset groupsBack tested hypothetical portfolio (1994-2018). Currency: EUR. Return Target: 4 per cent (p.a), Asset allocation determined using estimated historical 10-year expected returns for constituent asset classes. Risk constraints: 2.5 per cent (minimum volatility), to stop full de-risking. Source: Fidelity International, September 2018.

Achieving investment goals without unnecessary risks

Clearly, there is no silver bullet to address the multiple challenges facing investors, and appetite for risk is as varied as the goals investors set themselves.

Because risk isn’t a constant, what was acceptable in the past may no longer be so today. Risk is dynamic and that constant change has to be matched by an investor’s willingness to consider new strategies or asset classes to protect portfolios and improve returns.

We’re often asked what the cause of a future market crash might be. So far, risk-taking has been painless but we wonder whether global investors themselves might trigger the event as they rush to reduce risk once volatility has started to rise.

No set of circumstances is ever the same, and no solution is ever permanent. It all comes down to the investor’s goals, their ability to tolerate risk, the time horizon of the investments, and a willingness to reconsider allocations when circumstances change.

  • On the same subject: watch industry experts talk risk appetite in an uncertain world

David Buckle

David Buckle

Grethe Schepers

Grethe Schepers

Europe Editor