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Risk and return in challenging times

07 May 2019 Myra Knoesen

Risk is the single most poorly considered concept in financial theory, which is bizarre, because seeking best risk-adjusted returns is the first building block in investments, said Karl Leinberger, Chief Investment Officer of Coronation.

“Risk is not volatility, which is how it is defined in financial theory. In fact, risk is often highest when volatility is low, and complacency abounds. The US housing and banking market in 2006/2007, as an example, refers to risks that build up in times of prosperity and low volatility,” he said.

“We define risk as the risk of a permanent loss of capital. Risk means more things can happen than will happen. Just because your house did not burn down it does not mean you wasted money on insurance. We need to manage portfolios to cater for the risk that things do not pan out as we expect, especially given the increased frequency of high impact, low probability events,” said Leinberger.

A daunting task

At the Investment Forum Leinberger posed the question, in the investment arena, what is it we all seek to do? “We want to preserve capital. This is a daunting task given the risk of loss that is endemic in a complex world with an uncertain future. Change is also increasing at a rapid rate. With digital disruption, no industry is immune and artificial intelligence is disrupting jobs and industries,” he said.

“We want to protect capital from the ravages of inflation. A daunting task, given that inflation eroded 70% of the nominal purchasing power of the Rand in a fairly benign decade. We also want to grow capital. Another daunting task given the changes to longevity; growth essential to fund retirement draw-down periods unprecedented in our industry’s history,” he added.

“And then, we want to succeed in doing all these things over several decades. Given how many succeed over periods of a few years, but how few succeed over multi decade periods of time, this is another daunting task,” he continued.

“Contrast with day-to-day preoccupations, there is an obsession with performance over extremely short periods of time. It is all about the last month, quarter, year or few years with almost no reference to the most important return number; cumulative (compound) returns since inception. There is a focus on relative performance as opposed to what really matters to the client; the absolute risk-adjusted returns they will have to live off. Also, there is an obsession with return league tables; with far too little thought on risk taking to deliver those returns,” Leinberger emphasized.

Heightened risks in global markets

“We are coming off the longest period of unbroken economic growth in US history. How much longer can it last and with record levels of government indebtedness, how do authorities respond to the next downturn?” asked Leinberger.

“We are coming off the longest equity bull market in US history. Valuations are no longer in your favour, risk is higher when prices are high and many global equity markets are now fully priced, yet portfolios need global equity exposure to hedge SA risk,” he said.

“At a time of unprecedented levels of government indebtedness, there is ultra-low interest rates in the developed world. Complacency abounds after a decade of extraordinary low inflation. Economic populism is on the rise across the world which threatens to undermine globalization dividend. It is also likely to increase as AI continues to replace more and more jobs. China is currently in a fragile place; imbalanced and attempting to re-balance at a time of slow growth. We all watch the parliamentary circus with dismay of the Brexit risks in the UK,” he added.

“Risk is managed through capping exposure, higher exposure to much cheaper emerging markets and the tactical use of derivative hedges, said Leinberger.

“Meanwhile, back home, we all watch with dismay the unravelling of the hard work done in the first 15 years of democracy. In chronic loadshedding confidence is shattered, consumers and corporates go into their shells. However, loadshedding is needed to fix badly built power stations and years of backlog in maintenance. There is rising social tensions and economic populism; high unemployment rates, poor living conditions and rising levels of frustrations. Education is unravelling; only 37% of people starting school pass matric, only 25% of grade four kids can read for meaning and 11% of teaching time is lost to absenteeism. What if the recessionary conditions of the last few years are the new normal? Questioned Leinberger.

Key takeaways in managing risk

“Managing risk is deeply woven into our values and research process. A manager reaching for return at the expense of risk can get away with it for a few years, but not 25 years. Never forget you are managing retirement capital; the first rule of investments is not to lose money. You also do not know what the future holds,” said Leinberger.

“Risk matters more than return. Endeavour to build anti-fragile portfolios. Diversify the portfolio across sectors, industries, regions and currencies. Don’t allow portfolios to hinge on a few ideas, no matter how high conviction they are and cap exposure, no matter how high conviction the view is. Have a strong bias to high quality assets with good management teams. We find that this significantly reduces risk and that these businesses surprise with intrinsic value growth over time,” he continued.

“A generalist culture greatly reduces risk in the asset allocation process; a deep skill set across all asset classes working together in one integrated process. In order to manage risk, one needs a deep understanding of every single security in the portfolio; risk of unintended positioning without understanding look-through exposures,” added Leinberger.

Brendan McCurdy, Vice President at Goldman Sachs said, “Adding alternatives may provide meaningful risk reduction. Private equity provides attractive opportunities for return enhancement in the context of a disciplined, long term investment strategy. Investors use private equity in an attempt to enhance portfolio returns, gain access to companies not investable through public equities and help enforce a long term investment mindset. Private equity has historically outperformed public market counterparts over longer investment timeframes, partly through the engagement of active company management. Preparing investors for lockup periods may help avoid emotional selling during periods of uncertainty, and potentially help them participate in subsequent rebounds.”

Not all doom and gloom

Natasha Narsingh, Head of Absolute Returns at Sanlam Investments shared similar sentiments. “We are moving into low growth and you need to be active. We have uncertain times. You are not going to have a smooth journey as the years before. The uncertainty levels have gone up a notch e.g. Brexit, China/US markets, SOEs in SA, racial and political noise etc. We are managing expectations and it is not all doom and gloom. The question is, how much worse can it get?” She asked.

“The ability to deliver enhanced returns, being proactive users of strategies and diverse toolkits is critical in low returns. In portfolio construction utilize and look at all areas e.g. time horizons, broad diversification, tactical asset allocation, diverse toolkits and risk management of asset classes,” she said.

Editor’s Thoughts:
Leinberger stated that the future will not look like the past. Static allocations that worked in certain periods in the past will not always work in the future. Do you agree? Please comment below, interact with us on Twitter at @fanews_online or email me your thoughts myra@fanews.co.za

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