Risk: the perennial dilemma
Risk will always be an integral part of the investment process. The industry has become increasingly sophisticated and adept at managing risk within portfolios, but the world often presents new and unprecedented scenarios to ensure risk remains an ongoing challenge. This is certainly true of 2020. The pandemic has been disorientating and the world is a more uncertain place than it was at the start of the year. Yet, the objectives investors need to achieve remain the same. As we move into this brave new world, a wider mix of investment approaches may present the antidote needed to manage risk and meet ongoing liquidity requirements.
The Great Instability becoming the new norm
A new decade is often a time of change. However, the pandemic has served to exacerbate existing economic and market trends rather than launch new ones. Significantly, this means the search for yield has become even more acute. Emergency policy measures from central banks worldwide have ensured that interest rates will remain lower for even longer than expected. Consequently, yields for highly-rated government bonds will largely remain negative, proving harmful for pension funds and insurance companies which need to hold these assets for regulatory reasons.
After an initial sharp spike lower, equities have seemingly delivered some relief with the S&P 500 index establishing a new record high in mid-August. As ever, the headline performance disguises the reality. The broad technology sector has driven these changes, benefitting from pandemic-inspired changes in consumer and worker behaviour, but other sectors have been left shaken and stirred. Ultimately, volatility and uncertainty has escalated across all equity markets, raising the risk stakes for yield-hunters and leaving asset allocators to face some difficult choices.
Finding the right balance
Challenging situations tend to go hand in hand with complex decisions. Plans to lift lockdown restrictions in order to revive economic growth raised the risk of a second wave of the pandemic. A similar, but arguably less dramatic, choice is faced by investors when balancing a portfolio: access to sustainable sources of growth needs to be aligned with agreed risk parameters. Getting the mix right is crucial.
In this age of uncertainty, traditional assets are struggling to perform their traditional roles. As mentioned above, government bonds cannot be relied upon to deliver steady yields and while equities may be offering growth potential, a cautious approach is recommended amid ongoing volatility and general unpredictability.
Meanwhile, higher risk premiums for corporate bonds reflect the blow taken by company profits and credit ratings are deteriorating in line with the economy. Emerging markets face near-term risks amid rising debt and falling revenues, although this is reflected in reasonable valuations and the attractiveness of countries is highly variable. Notably, market performance in China has benefited from supportive government and central bank intervention, as well as its high share of outperforming tech companies.
Looking beyond the traditional in unconventional times
With the upcoming US presidential election, ongoing trade tensions and an emboldened China, the coming months are unlikely to offer much respite. This means the search for safer, relatable and less volatile places to invest, while still strategically managing risk, may require a broader perspective.
This is particularly true for institutional investors, where the risk/reward juggling act needs to find innovative ways to meet the varying and complex regulatory requirements both in Europe and globally. Taking pension funds as an example, they need to fulfil long-term growth commitments, which require investments in risk assets, while adhering to strict risk constraints, such as maximum drawdown or volatility levels.
In today’s low-return world, fulfilling these needs and obligations through traditional assets is harder to achieve. An alternative approach is to consider alternative investments. Non-traditional assets encompass a wide range of investment strategies and can offer some attractive diversifying attributes such as low correlation to traditional assets. Once seen as a niche area, the search for yield over the last decade has seen them rise to a place of prominence in many portfolios.
As well as operating in traditional markets, alternatives can provide access to less mainstream investment opportunities. Structured finance focuses on cash-flow generating assets; real assets strategies, such as infrastructure and commercial real estate debt, provide long-term exposure to large-scale, physical assets like airports, roads and buildings and can earn an illiquidity premium comparable to similarly-rated corporate bonds; whereas factor investing seeks to generate higher risk-adjusted returns from proven drivers of traditional assets such as quality, value, momentum and low volatility.
The economic and investment landscape currently feels very different to what has been experienced previously. A new perspective that looks beyond traditional assets may be the key to building robust portfolios, better able to withstand negative market developments. Yet, it remains imperative that any solution continues to factor in a core understanding of investment goals and attitude to risk.
Risk astute investing
There is no avoiding risk – it’s all around us, especially as investors. Yet the pandemic and resultant economic turmoil have amplified this – fuelling uncertainty and making it impossible to accurately predict market behaviour. And while this world of chaos persists, the demand for investment returns continues and intensifies the pressure to find sustainable yields and satisfy liquidity obligations.
As investors, we need to adopt a heightened sense risk-awareness. Blending caution and ingenuity by incorporating a broader, deeper and alternative approach could help navigate these unpredictable times.
At BNP Paribas Asset Management we understand that the current environment is unnerving for our clients. That’s why we look at problems from multiple angles. We challenge both the normal and abnormal to consider whether what has worked before will still work now. Maybe sticking to the status quo will prove to be the right path, but an alternative route may end up meeting our clients’ needs more effectively. Either way, we investigate before we invest.
We have a dedicated, multi asset and client solutions team exploring ways to help our institutional clients meet their investment and regulatory needs. To do this, we utilise a wealth of experience and expertise, scrutinise the latest research and challenge conventional thinking.
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