Practice Strategies
A New Perspective On Risk: Comment

With the massive evolution of fiscal and monetary policy that began in 2008, accelerated by COVID-19, the asset management CEO and author of this commentary reviews how such a "regime shift" has altered the nature of risk itself.
Considered "the long read" but worth a few minutes is this reflective look at how the last few months have reframed risk: taking it, pricing it, and dispersing it. The author is Unigestion's CEO Fiona Frick, who offers her views on actively managing in this new environment, where all-in easing has created unlimited demand for financial assets. "The scale and scope of current monetary policy has been so large and broad that it has potentially destroyed the historical relationship between fundamentals and market pricing," she said. We welcome publishing these longer thought pieces from time to time. The usual disclaimers apply. For feedback, email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com
We are facing a regime shift that alters the nature of
risk itself
“One doesn’t discover new lands without consenting to lose sight
of the shore”. This quote from French author André Gide is a good
reminder that, as we begin to emerge from the COVID-19 crisis, we
should consider what new lands there are to discover in financial
and economic theory.
We believe that the Great Financial Crisis (GFC), followed by the COVID-19 pandemic, has modified the functioning of financial markets for the long term. Massive interventions by central banks, designed to save the global economy from major dislocations, have impacted some of the financial concepts we have been learning and applying for decades. Investors need to revisit those concepts with fresh eyes and update them where necessary for a new era.
One fundamental pillar of finance theory that warrants review is
portfolio construction. Harry Markowitz’s hugely influential
Model Portfolio Theory (MPT), conceived in the 1950s, not only
provided investors with a means to measure risk and
diversification, but also allowed them to quantify the marginal
benefit of adding new exposures in order to derive the optimal
portfolio allocation. While MPT was a dramatic leap forward in
financial thinking, we believe many of its foundational
assumptions hold with difficulty in real life. This is especially
true in the current environment, where large-scale quantitative
easing has structurally modified the relationship between assets’
risk and return expectations.
A new perspective on risk
With the massive evolution of fiscal and monetary policy that
began in 2008 and accelerated with the COVID-19 outbreak, we are
facing a regime shift that alters the nature of risk itself. As
government bond rates are low and central banks have acted to
reduce spreads for riskier assets, the risk attached to an
investment today is not a reflection of its true risk.
The difficulty of pricing risk
One of the bases to price risk is to start by defining the
risk-free rate, i.e. the theoretical rate of return from an
investment with zero risk of financial loss. US Treasuries and
government bonds from other highly-rated countries are widely
considered to be risk-free assets, as they are fully backed by
their governments. This is true in a sense, as highly rated
governments have always fully paid back their debts in nominal
terms. However, what many investors miss is the fact that the
purchasing power of those bonds is not guaranteed due to
inflation. There are two issues with the current nature of risk:
risk premia are compressed, and the risk-free rate is lower and
more risky.
Taking risk is a multi-dimensional, active
act
Despite the well-known limitations, historical volatility is
often used as shorthand for riskiness in some popular risk
management models, including the MPT framework. For us, risk
cannot be reduced simply to one backward-looking statistic.
First, it has to be about permanent loss of capital, which is the
true risk investors face. Second, it should be measured using a
multi-dimensional approach that is linked to the current
environment. The COVID-19 crisis is a perfect example of that, as
investors were faced with new risk metrics to assess, such as the
contagion rate of the pandemic and the potential duration and
impact of lockdowns on the economy.
The very expression ‘risk premium’ suggests that taking risk generally accompanies returns. However, given the multi-dimensional nature of risk, we are convinced that risk management needs to be active. It also needs to be dynamic in order to adapt quickly to changing market conditions. We believe this will be essential to navigate a number of key risks that are mounting today. These include:
1. Credit risk
While the present crisis is not caused by debt, the economic side
effects of global lockdowns are likely to significantly increase
credit risk going forward. Although short-term risk is managed,
long-term credit risk will rise. Central banks buying credit have
reduced the perceived tail risk of credit. Their action, together
with fiscal policies put in place by countries, will be an
incredibly powerful tool for our economy and will enable many
individuals, companies and local governments to survive an
economic decline that would otherwise be devastating. However,
credit risks are growing in the economy due to credit
misallocation and increased solvency risks. We are experiencing a
situation in which many countries and companies, already highly
leveraged, are taking on more debt.
In recent decades, investors have favoured companies that rely on financial engineering, such as increasing debt or implementing stock buybacks, to maximise their profitability. However, the COVID-19 crisis has shown that prioritising purely profitability creates fragility. In these uncertain times, identifying resilient companies will be key. Fundamental ratios that have been forgotten over the past decade, such as debt-to-equity, interest coverage and cashflow robustness, will move centre stage.
2. Government intervention/financial repression
risk
The huge amount of government debt accrued during the current
crisis ultimately will have to be repaid, be it through higher
taxes, inflation or other financial repression measures, meaning
that longer-term tail risks have increased. In emerging markets,
government regulations, such as de facto caps on profits for
utilities, have been quite common, but we could now see similar
situations arising in developed countries across various
industries, such as utilities, automobiles or airlines. For
example, the French government’s €15 billion support package for
the aerospace industry will have some strings attached on how
companies run their business models. This new type of risk, which
econometric models can only assess retrospectively, highlights
the importance of combining systematic analysis with
forward-looking fundamental research. Understanding
government-related risks also has implications for asset
allocation and may challenge some traditional models that favour
large weightings in the US, for example.
3. Liquidity risk
Liquidity risk is volatile, but generally strikes at the worst of
times, so it is better be prepared for it. March and April showed
the eruption of an unprecedented liquidity crisis in financial
markets, when even government bonds experienced spread increases
never seen before. This shows that liquidity is one of the most
critical, but least quantified risk dimensions in portfolio
construction.
Traditional portfolio construction techniques, including mean-variance optimisation or risk parity, focus heavily on return variability and drawdowns, but often treat liquidity risk as a secondary consideration. At Unigestion, we believe that liquidity risk should be a direct input in portfolio construction and we include it on an ex-ante basis in our proprietary Expected Shortfall model to assess risk.
4 ESG risk
ESG risk is an increasingly important consideration for
investors. Well before the current crisis materialised, we were
living in an era of rising inequalities and increasing urgency
around the climate change challenge. However, we believe that the
COVID-19 outbreak has brought us to a tipping point and we are
witnessing a change of regime where society will no longer
tolerate these imbalances and fragilities.
Companies that do not pursue sustainable practices on a day-to-day basis create operational and reputational risks within their businesses and to their business model. Meanwhile, new regulation can make or break entire industries and can have a direct impact on the companies in which we invest. Anticipating and avoiding these risks will be key. At Unigestion, we expect ESG integration to be beneficial for long-term risk and therefore long-term risk-adjusted returns, although we do not support a positive or negative relationship between ESG criteria and performance in theory.
Does diversification still work?
A second key concept to revisit is diversification, which has
been the cornerstone of investing since Markowitz published his
seminal article, Portfolio Selection, in 1952. The benefits of
diversification across assets have been challenged over the last
10 years, when few strategies would have beaten a simple 60/40
portfolio comprising US equities and government bonds. The magic
behind diversification is that a portfolio of assets will always
have a risk level less than, or equal to, the riskiest asset
within the portfolio. The theory has its shortcomings, however,
and unfortunately, diversification can fail dramatically during
market crises, just when investors need it most.
During the COVID-19 market crisis, there has been an unprecedented rise in correlation between different asset classes. Certain assets have fared better than others, but the list of winners during the initial sell-off was very short and bonds did not offer the level of protection they have in the past, in part due to their low level of yield. Diversification across global equity markets has not paid off either. Correlation between global stock indices generally decreased following the GFC but spiked again with the COVID-19 outbreak. Structural changes, including significant growth in passive investment strategies, high frequency trading and factor investing, have amplified those behaviours during the crisis.
Dispersion set to increase
At Unigestion, we continue to believe in diversification and
consider its recent failure to be a cyclical phenomenon, notably
due to the unprecedented central bank action, which led to a
concentration in most traditional assets. As was the case after
the GFC, we expect correlation and dispersion to become more
favourable to diversification.
Generally, diversification does not tend to pay off during the first leg of a significant market correction, when systematic de-risking negatively affects all stocks indiscriminately, but we expect more dispersion to materialise in the coming months. Furthermore, prior to the COVID-19 outbreak, economic growth had been the key driver of market performance for more than a decade.
This should change as we move into a more volatile economic
environment that should be discriminatory in terms of countries,
sectors and styles. Different risk premia should start to respond
differently again. However, the rise in correlation, together
with heightened market volatility, suggests that a reappraisal is
required when seeking diversification.
Enhancing diversification across macro
regimes
We believe that diversifying across asset classes is too
simplistic since the underlying risk drivers can be the same.
Instead, a portfolio should be diversified across macroeconomic
regimes and invest into assets that respond differently to these
macro conditions. Our research shows that the macroeconomic
environment typically falls into one of four regimes – steady
growth, recession, inflation shock and market stress – which tend
to occur with a similar frequency across all regions and periods.
We believe it is important to ensure that portfolio risk
allocation is aligned with the long-term probabilities for the
various regimes. It is also essential to adapt portfolio
positioning as market conditions change.
Today, we are at a spectacular juncture in terms of the macro and market cycle. Our economy is facing a deep recession due to an exogenous shock and the efforts of central banks and governments will have a huge influence on the return to growth trajectory. However, this potentially creates a risk of inflation. Furthermore, while markets stabilised in April thanks, here again, to central bank intervention, we believe that they are vulnerable to other stress events. In our view, a robust portfolio should have some exposure to all these outcomes.
What does value mean?
We are in new territory where ‘All-in Easing’ has created
unlimited demand for financial assets, raising the question: what
does value mean? The scale and scope of current monetary policy
has been so large and broad that it has potentially destroyed the
historical relationship between fundamentals and market
pricing.
We are witnessing some valuation distortions across asset classes
because 1) the risk-free rate is distorted and 2) we have a buyer
of last resort for a large spectrum of risky assets. Government
bond yields in the US and other large economies reflect the
return investors can expect to earn without taking risk, which
serves as the foundation on which you build every asset’s
expected return. If government bond yields are distorted, so too
are the prices of stocks, corporate bonds and everything else.
Moreover, central banks extending their programmes beyond
investing in government bonds reinforces the compression of risk
premia being embedded in any risky asset.
There are also valuation distortions within asset classes. The
dispersion between equity valuations in particular is massive. As
of the end of April, the top 20 per cent of stocks from each
S&P 500 sector combined are trading at 27 times their
earnings, compared with a multiple of 14 for the bottom 20 per
cent of stocks within the same sectors.
Is value investing dead?
These distortions have raised questions about whether value
investing has run its course. Value style has experienced an
extraordinary period of underperformance relative to growth
investing, spanning more than 13 years. Value has become so cheap
versus growth that its current valuation is in the 97th
percentile of its historical distribution. A number of narratives
have been offered to explain why the value factor’s poor relative
performance may be the ‘new normal’. One such theory is that the
value definition has become obsolete.
It is true that value can no longer be defined solely as book
value, as proposed by the Fama-French model, but for every
definition of value we examine in measuring relative cheapness –
price-to-book, price-to-earnings, price-to-sales and
price-to-dividends – it has underperformed growth since 2008.
Furthermore, the definition of ‘cheap’ is no longer limited to
industrial companies, cyclical stocks or financials. Looking at
the one-year return for the value factor by sector (as at end
May), there were no sectors with a positive value spread in
Europe and only one in the US.
Factor premia, including value, still exist
We see no reason why the value premium should have disappeared.
Such a lost decade is not unprecedented in history and variations
are still well within the range that may be expected
statistically. Indeed, value performance in the 2010s was
remarkably similar to the 1990s, which is perhaps unsurprising
since both these decades also saw double-digit excess returns for
the equity market.
Factor premia, including value, still exist and should deliver long-term performance. However, their performance in the short term can be quite cyclical and extreme. For that reason, we prefer a diversified factor exposure in our risk-based equity strategy, rather than favouring any one factor, and use our Nowcaster indicators to adapt our factor exposures to the prevailing market environment.
It is not surprising that the dispersion of valuations is so extreme. The dispersion of earnings estimates for S&P 500 companies is also at its widest, as a record number of firms have suspended their guidance. The number of US blue-chip companies offering full-year guidance with their first-quarter earnings has halved in 2020. In a period where earnings are so difficult to estimate, even for companies themselves, short-term valuations become less meaningful, especially so when using systematic measures. There is a need for more holistic fundamental analysis to review the long-term value proposition of a company to be able to derive its long-term valuation.
Delivering for clients in a changing
environment
Paul Samuelson, winner of the Nobel Prize for Economics,
responded to criticism that he had changed his view on the
acceptable level of inflation by saying: “Well when events
change, I change my mind. What do you do?” We can admire the
humility necessary to answer in this way all the more when coming
from a Nobel laureate. We can also learn from it when our
environment is changing, as has been the case lately.
As asset managers, we need to have a certain humility to accept the fact that we do not know anything for sure. Nevertheless, it is still possible to deliver for our clients even in uncertain times and this is what we mean by active risk management, which lies at the heart of our investment philosophy. We can never be sure of an outcome, but we can prepare for it and decide which risks we are comfortable taking and those we are not.