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Active risk management in a changing market environment

Risk management has always been at the forefront of thinking when analyzing financial markets.  But, when the environment for financial markets changes - how does risk management?

We believe that in today’s financial markets, we are experiencing a paradigm shift in terms of economic conditions, central bank policy and investors’ perception. In our view, a true understanding of the risk-reward potential of each investment and the contribution it can make in a portfolio context will be more important than ever as we move into the next phase of the market cycle.

The current environment requires a significantly different, much more selective approach to risk allocation than the one that has prevailed over the last 10 years.

"Financial markets are complex: they are highly interconnected, non-linear and adaptive."

Actively managing risk, and having the flexibility to adapt, will be essential. In a period where economic growth is decelerating, growth assets such as equities, private equity and credit should be treated with care.

During previous slowdowns, government bonds have acted as a powerful diversifier, but their hedging capabilities are now more limited.

Investors need to broaden the tools they use to diversify their portfolios to include a different exposure to equity and a larger allocation to alternative asset classes.

A cautious approach to growth assets

As the road to market turning points can be long, it will be important to remain cautiously invested in growth assets, such as equities. Increased volatility and slower profit growth are likely to dampen investor appetite for pure market beta exposure in the years ahead and to create more differentiation in returns.

An active approach will be crucial to navigate the transition. Passive strategies are too prone to excesses as they make no provision for risk allocation and are more likely to be invested in overvalued, overcrowded positions that are vulnerable to sharp corrections.

In this environment, we favour investing in diversified portfolios of quality stocks with reasonable valuations that will be better positioned as the cycle moves from expansion to recession.

We also recommend dynamically implementing hedges using futures and options to reduce equity exposure when the probability of market stress increases.

For us, this disciplined risk budgeting approach is the best way to capture the equity return premia while ensuring downside resilience, increasing the positive asymmetry of returns.

Diversification through alternative risk premia

However, after a decade of strong, relatively uninterrupted growth, traditional asset classes are unlikely to deliver as they have in the past and investors will need to find alternative, uncorrelated sources of return.

For investors seeking cost-efficient and transparent portfolio diversification, liquid alternative risk premia strategies (ARP) offer a compelling solution, having delivered positive long-term returns with a very low correlation to equities and bonds.

"The current environment requires a significantly different, much more selective approach to risk allocation than the one that has prevailed over the last 10 years."

At the heart of risk premia investing is the idea that investors are compensated for accepting risks rather than buying assets: a risk premium is the reward for taking on a specific investment risk.

The advantage of ARP strategies is that they remove most market directionality by taking long/short positions to gain a purer exposure to the desired risk premia, thereby enhancing diversification benefits.

Private equity as a performance booster

A selective allocation to private equity also offers strong potential to enhance overall portfolio performance.

Historically, private equity has performed well in late-cycle environments and has been an effective hedge against rising (or unexpected spikes in) inflation.

While private company valuations may fall during an economic slowdown, the declines are usually less pronounced than in public markets.

In addition, private equity is one of the few asset classes forecast to deliver high single digit returns in the next cycle. While some caution is needed, the breadth of the private equity market today allows investors to carefully manage their exposure to favour more defensive sectors or those benefiting from long-term secular trends, such as the ageing population or decarbonisation of our economy.

It will also be important to invest in companies that are resilient in their own right thanks to strong market position, management and financials and can therefore deliver the required base case return through revenue growth and operational improvements.

With competition high, we favour strategies that allow sourcing deals outside of large auctions, such as small and mid-market buyouts, which are by nature less competitive.

In addition, the small and mid-market is less correlated to GDP growth and currently enjoys lower leverage and valuations.

A long-term, contrarian view

Looking further ahead, we believe that changing market dynamics will require investors to take a longer-term view when allocating to risk and to be capable of being contrarian for longer.

Financial markets are complex: they are highly interconnected, non-linear and adaptive.

Market behaviour is driven by investor behaviour, but investor behaviour itself is shaped by market behaviour. This recursive relationship, known as reflexivity, can play a role in creating and sustaining positive feedback loops.

Boom and bust cycles are a natural consequence of a system in which the interactions between the participants are more significant than the actions of any participant in isolation and, much like in the natural world, they are the enduring forces that allow markets to move back into equilibrium.

However, this self-regulating mechanism could be put at risk by exponential growth in rules-based investment strategies, notably passive, smart beta, risk parity and target volatility strategies.

Too much homogeneity in market participant actions can create self-fulfilling phenomena, leading to a more fragile investment environment where trends tend to persist longer, but often reverse more brutally.

In this scenario, we believe investors will need to accept higher tracking error and longer periods of relative underperformance in order to build outperformance over the long term.

The real deal

Investors should not forget that the real investment risk they face is losing capital, not tracking error, and that they need to take active decisions in order to avoid permanent loss of capital.

While many investors claim they invest for the long term, it is very rare that short-term performance does not come into consideration.

Adopting a truly long-term approach to investment is one of the few genuine opportunities investors can hope to exploit. However, it may require standing against the crowd and having the courage to look far enough ahead.

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