managing portfolio risk: a long-standing marriage of art and ......2015/03/12 · 2012 2013 2014f...

Managing portfolio risk: A long-standing marriage of Art and Science

March 2015

Dr. Epco van der Lende, Head of Multi-Asset Solutions

2

Definition of investment risk?

Definition is ambiguous

“The chance that an investment's actual return will be different than expected” Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. A high standard deviation indicates a high degree of risk.

INVESTOPEDIA

“Risk implies future uncertainty about deviation from expected earnings or expected outcome” Risk measures the uncertainty that an investor is willing to take to realize a gain from an investment.

THE ECONOMIC TIMES

“The possibility of financial loss”

OXFORD DICTIONARIES

“The probability that an actual return on an investment will be lower than the expected return”

BUSINESS DICTIONARY

3

Investment risk decomposed

Image : Cartoon Stock

Risk perception What is my most relevant risk?

Volatility, Value-at-Risk, solvency, liquidity, return target,….

Risk assessment How do I measure risk?

Quantify actual portfolio risk profile / level

Risk management How do I prevent or manage risk?

Engineer an appropriate portfolio risk profile where risk stays at an acceptable level

4

Evolution of investment risk: Stage 1

…..Evolution of risk…..

In the beginning there was Art…

Absolute / real return target

Realized return levels / track record

Qualitative: conviction-based

Worked fine until it did not Subjective: too unpredictable, lack of repeatable process

Risk perception

Risk assessment

Risk management

Image : Cartoon Stock.

5


Where it all began…


…Then “objective” Science took over…

Volatility, shortfall, (conditional) Value-at-Risk,… relative return, tracking error

Model or data-based measurements and statistics

Quantitative: optimization, diversification, statistical modeling

Worked fine until it didn’t

Quasi objective: Model limitations, forecasting versus explaining, fat tails, quantifying the unquantifiable, data problems, model risk, lack of transparency, irrelevance

Risk perception

Risk assessment

Risk management

Image : Cartoon Stock.

6


Where it all began…


…Art and Science, a happy marriage?

Bespoke objective-based return target

Model or data based measurements and statistics, “new” risk indicators, e.g. turbulence, regimes, absorption

Quantitative: objective-based optimization, stochastic modeling / stress-testing / qualitative assessment

Works…? Realistic: Awareness of model limitations and a need for skill/art/relevance

Risk perception

Risk assessment

Risk management

Image : Cartoon Stock

7

So where do we go from here?

Regimes

Turbulence

Absorption

“Aggregate market abnormality”

“Persistence or Incident”

“Aggregate market brittleness”

Absolute / real return Multi-asset growth, search for yield Renewed focus

New types of risk indicators

8

Art and Science, working hand in hand

Regimes “Persistence”

Turbulence “Abnormality”

Absorption “Brittleness”

Measured by multivariate distance measure of latest asset returns versus history

(Squared Mahalanobis Distance)

Widely applied and well-proven mathematical way to identify and distinguish not directly observable states

Hidden Markov Model (HMM)

Measured by marginal percentage of variance explained by adding principal components

𝑑𝑡 = (𝑦𝑡 − μ) ∑−1(𝑦𝑡 − μ)𝑇

𝐴 𝑛 − 𝐴 𝑚 =𝑉𝑎𝑟 𝑃𝐶1..𝑛

𝑉𝑎𝑟𝑇−

𝑉𝑎𝑟 𝑃𝐶1..𝑚

𝑉𝑎𝑟𝑇

9

Global Assets

Turbulent

Non-turbulent

Current regime: Ex-Normal – Implying higher returns and higher volatility Regime 1. Persistence: 83.11%/90.67%, µ: 113.31%/73.03%, σ: 32.11%/14.55%, P(switched)=100.00%

Run Date: 16-Feb-2015 12:26:50, Latest Data: 13-Feb-2015

Source: First State Investments

WARNING: Global Assets turbulence ahead

10

Fixed Income and Commodities

WARNING: Fixed Income and Commodities turbulence ahead

Current regime: Ex-Normal – Implying higher returns and higher volatility Regime 1. Persistence: 88.15%/96.32%, µ: 156.56%/81.79%,

σ: 50.96%/16.66%, P(switched)=100.00% Run Date: 16-Feb-2015 12:28:21, Latest Data: 13-Feb-2015

Current regime: Ex-Normal – Implying higher returns and higher volatility Regime 1. Persistence: 95.04%%/91.79%, µ: 104.64%/86.50%,



11

Risk factors and brittleness?

WARNING: Factor-based and brittleness turbulence ahead

Current regime: Ex-Normal – Implying higher returns and higher volatility Regime 1. Persistence: 94.14%%/89.56%, µ: -1030.57%/-1731.44%,


Current regime: Ex-Normal – Implying higher returns and higher volatility Regime 1. Persistence: 87.81%/92.30%, µ: 122.31%/72.04%,



12

Steering through troubled waters The asset class perspective

Fixed Income

Equities

Nigel Foo, Senior Portfolio Manager, Asian Fixed Income

Petr Kocourek, Senior Portfolio Manager, Multi-Asset Solutions

Image source: Thinkstock

Lower forever?

March 2015

Nigel Foo, Senior Portfolio Manager, Asian Fixed Income

14

2013 taper tantrums

Image: Thinkstock

15

Global bond yields can’t stop heading lower

Source: Bloomberg. Data to 31 December 2014.

Developed markets 10 year bond yields (%)

16

Lower market volatility

Source: Mckinsey Global Institute. Data to 30 November 2013.

Abundance in liquidity lowered market volatility

17

Ultra Easy monetary policies

- Zero interest rate policy

- Quantitative Easing

No inflation - Slack in labor market

- Consumer still cautious

Why are yields so low?


Weak Growth - US grow is just picking up

- Europe stuck in low growth - Japan struggling and China is

slowing

Conditions leading to low interest rate still intact

18

Fed stopped but BoJ and ECB doing a lot more!

Source: Bloomberg. Data to 28 February 2015..

Central bank balance sheets % GDP

19

Structurally lower interest rate?

US interest rate has been in a downtrend since 1980s suggesting we could be in a structurally low growth, low inflation and hence, low yield environment

Source: First State Investments and Bloomberg. Data to 28 February 2015.

20

Where does that leave us in 2015 ?

Key to success is correctly identifying the risks & opportunities and actively managing them

Key risks actively monitored

Key opportunities

Implications

• The Asia growth story

• Pockets of value in credit

• Interest rates hike

• Credit quality

• Global collaboration

• In-depth regional expertise

Image: Thinkstock

21

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Standard and Poor’s

Investment grade default 7 13 3 1 1 - - 14 11 - 1 - -

Sub-investment grade defaults 173 158 89 38 31 25 21 89 224 64 43 66 64

Default rate (%) 3.8 3.5 1.9 0.8 0.6 0.5 0.4 1.8 4.1 1.2 0.8 1.1 1.0

Moody’s

Investment grade default 4 12 - - 2 - - 14 11 2 1 1 1

Sub-investment grade defaults 183 126 82 37 29 31 18 89 254 56 36 57 65

Default rate (%) 4.3 3.3 2.0 0.9 0.7 0.7 0.4 2.2 5.9 1.4 0.9 1.4 1.4

Global Credit Income Fund

Investment grade defaults - - 1 - - - - 2 - - - - -

Sub-investment grade defaults - - 2 - - - - 4 - - 1 - -

Default rate (%) - - 1.0 - - - - 1.3 - - 0.2 - -

Asian Quality Bond Fund

Investment grade defaults - - - - - - - - - - - - -

Default rate (%) - - - - - - - - - - - - -

Avoiding defaults is crucial!


22

Investment Opinion Management (ION) Global collaboration and risk-sharing platform

Australian Fixed Income

Global Credit Emerging Markets

US Fixed Income*

Asian Fixed Income

Short-Term Investments

Fixed Income & Multi-Asset Solutions

Multi-Asset Solutions

* US Fixed Income team is pending regulatory approval

Collaborative, long-term investment outlook underpinned by common research standards

Different team processes united by an investment culture underpinned by Investment Opinion Network (ION)

23

-2

0

2

4

6

8

US Eurozone Japan EMEA Latin America Asia ex-Japan

Real GDP Growth

2012 2013 2014F 2015F

Asian Fixed Income – the regional bright spot

Source: Bloomberg and First State Investments as at 31 July 2014 *percentage of region in EMBI Global index.

31.6%* 35.8%*

19.8%*

Asia has stronger growth vs peers but is under- represented in major bond indices

%

Turbulent times: A practical survival guide for equity investors

March 2015

Petr Kocourek, Senior Portfolio Manager, Multi-Asset Solutions

25

Central banks From squelching volatility to currency wars

Phase 1 Quantitative Easing

Phase change

Phase 2 Currency wars

• More inward-looking

• Abandoned the game of “Volatility Whack-a-mole”

• QE was not enough, currency depreciation is the next tool

• Exporting repressed volatility from bonds to currency markets

• Widespread impact of currency shenanigans:

• Japan, Switzerland, Denmark, Singapore, Australia, New Zealand, China

• Panama? Ecuador? Hong Kong... next?

• Post-GFC central banks went on their QE-spree

• Using heavy weaponry to get long yields down

• Also using large sacks of money to squelch volatility

Image: Thinkstock

26

How central banks distort information flows

Re-pricing of risk assets is an intended feature of central bank distortions, not a bug!

Price distortions Global and massive mispricing of assets

• The price of money

• The price of credit

• The price of currency

• The price of equities

What is affected?

• Prices convey and contain information

• Central banks have been manipulating the prices

• In effect conducting massive financial propaganda campaign

• Information can be suppressed

• But underlying reality will manifest itself

• Even if not through traditional price mechanisms

27

When everything is expensive…

You can’t really trust prices anymore; besides, everything looks expensive!

• Fixed Income

• (Some) short maturity bonds and cash have negative (nominal) yields

• Long bonds justify their pricing solely on the back of central bank buying

• Commodities

• Deflationary spiral after a decade-long boom

• Equities

• Richly valued (and appears to be defying gravity)

• Sitting on the sidelines is not an option!

• Objectives need to be met

• Spending needs to be financed

• Pensions need to be paid…

• Implications for investors

• Better and different tools to guide your portfolio

• A fundamental rethink of what risk is

Image: Thinkstock

28

Risk is not a number

Assuming the past is the natural state of markets is falling prey to recency bias.

• Risk models are sensitive to the (generally historical) inputs

• Asset class correlations are time-varying and exhibit asymmetry

• Time-varying correlations (and risk measures) provide a challenge to traditional risk models

Just because things have been a certain way recently does not mean they will stay the same.

Optimising allocations based on historical volatilities and correlations can lead to higher than intended risk.

Source: Bloomberg, Internal proprietary models. Data to 31 December 2014

-1.00

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

Mar 1

98

8

Jul 1

98

9

No

v 199

0

Mar 1

99

2

Jul 1

99

3

No

v 199

4

Mar 1

99

6

Jul 1

99

7

No

v 199

8

Mar 2

00

0

Jul 2

00

1

No

v 200

2

Mar 2

00

4

Jul 2

00

5

No

v 200

6

Mar 2

00

8

Jul 2

00

9

No

v 201

0

Mar 2

01

2

Jul 2

01

3

No

v 201

4

Annualized CorrelationEquities vs Bonds

8-Quarter Rolling 20-Quarter Rolling 40-Quarter Rolling Since 30-Dec-86

29

Detecting uncharacteristic market behavior

To monitor regime shifts we determine a measure of abnormality in data or process for the identification of outliers.

• Turbulence in foreign exchange markets seen during the major events:

• The British government forced to withdraw the pound sterling from the ERM

• Russia devaluing the Rouble, defaulting on their debt

• The Global Financial Crisis

Turbulence captures extreme price movements and changing relationships

Turbulence = Mahalanobis distance = recent sets of returns vs history

Source: Bloomberg, Internal proprietary models. Data to 28 February 2014.

0

2

4

6

8

10

12

1978 1982 1986 1990 1994 1998 2002 2006 2010 2014

Tu

rbu

len

ce

In

de

x

FX Monthly Turbulence

SNB removal

of floor

European Debt

Fears

Global Financial Crisis

Russian Default

Black Wednesday -

Soros Breaks BoE Free Float

AUD – Dec

‘83

Introduction

of ERM

30

Capturing regime shifts

• A new regime for commodity markets?

• The implications of the regime change are likely to be:

• Positive for global growth and reduction of inflationary pressures.

• Emerging markets such as China, India and Turkey will be the beneficiaries of a lower oil price; especially in manufacturing and agricultural sectors.

Commodity markets: The precipitous fall in energy prices caused a regime shift

Global equity sectors: Signs of flow-through; increased turbulence has been visible for some time

Source: Bloomberg, Internal proprietary models. Data to 30 September 2014

31

So how do we deal with this in our portfolios?

• De-risk when turbulence started to go up

• Reduced equity and FX exposures, bought put options, hedged out duration

• Main driver of risk and returns is now European equities and FX

o Partially protected by put options

• Additional asymmetry through far out-of-the-money call options for upside in case of a Grexit meltdown

Higher risk / Higher turbulence

Hig

her

ret

urn

po

ten

tial

Japanese Equities

US Equities

Commodities

Developed Sovereign Bonds

FX

European Equities

Asian Bonds

Latin America Bonds

Source: First State Investments.

32

Risk managed relative to objective

99

100

101

102

103

104

105

106

107

108

109

110

111

112

113

114

115

116

117

118

119

120

30-Nov-12 31-Jan-13 31-Mar-13 31-May-13 31-Jul-13 30-Sep-13 30-Nov-13 31-Jan-14 31-Mar-14 31-May-14 31-Jul-14 30-Sep-14 30-Nov-14 31-Jan-15

Real Return Fund Gross Performance

Real Return Fund (Gross)

Sharpe Ratio 1.81 since inception, volatility 3.1%

Source: First State Investments. Data to28 February 2015.

33

Disclaimer

The information contained within this document is generic in nature and does not contain or constitute investment or investment product advice. The information has been obtained from sources that First State Investments (“FSI”) believes to be reliable and accurate at the time of issue but no representation or warranty, expressed or implied, is made as to the fairness, accuracy, completeness or correctness of the information. Neither FSI, nor any of its associates, nor any director, officer or employee accepts any liability whatsoever for any loss arising directly or indirectly from any use of this document.

This document has been prepared for general information purpose. It does not purport to be comprehensive or to render special advice. The views expressed herein are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an investment recommendation. No person should rely on the content and/or act on the basis of any matter contained in this document without obtaining specific professional advice.

The information in this document may not be reproduced in whole or in part or circulated without the prior consent of First State Investments. This document shall only be used and/or received in accordance with the applicable laws in the relevant jurisdiction.

Past performance is not necessarily a guide to future performance. The value of investments and income from them may fall as well as rise and the investor may not receive back the amount invested. Investments may be in a variety of currencies and therefore movements in the value of currencies may also affect the value of an investor’s holdings. Furthermore, the value of investments may be adversely affected by fluctuations in exchange rates between the investor’s reference currency and the base currency of the investments.

International investing involves certain risks including currency fluctuations and controls, nationalization or expropriation, confiscatory taxation, restrictions on foreign investments and on repatriation of capital, less governmental supervision and regulation, less liquidity, the potential for market volatility and political and social instability.

High yield securities; investment in higher yielding securities is speculative as it generally entails increased credit and market risk. Such securities are subject to the risk of an issuer’s inability to meet principal and interest payments on the obligations (credit risk) and may be subject to price volatility due to such factors as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity.

This study has been made by First State Investments (Singapore). The analysis made requires the use of quantitative instruments that make assumptions on risks and returns in the forecast horizon. This analysis, although made to our best efforts and insights, cannot be an indication for returns achieved in reality, First State Investments (Singapore) cannot accept responsibility for the advice given.

This document is issued by First State Investments (Singapore) whose company registration number is 196900420D. First State Investments (registration number 53236800B) is a business division of First State Investments (Singapore).

managing portfolio risk: a long-standing marriage of art and ......2015/03/12 · 2012 2013 2014f...

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