Traditional investment processes struggle to incorporate new sources of risk such as COVID-19. In response, some fund managers are taking a fresh and more comprehensive approach to risk management.
Ben McCaw is a portfolio manager with MLC Asset Management. McCaw explains most fund managers approach potential threats in a very generic way. They analyse the risk reward relationship and take an established approach to asset allocation. But when markets are volatile, it’s often more valuable to be specific about risks that could cause underlying uncertainty in a portfolio.
“Using our Investment Futures Framework, we’re able to identify a broad range of left-field events that may affect assets,” he says. It’s akin to doing scenario analysis.
“Our process includes an assessment of a wide set of credible, but perhaps remote, possibilities that are important for managing investment risk. This includes political uncertainties and pandemics, as well as depression and recession scenarios. So, when a risk such as the coronavirus outbreak becomes a reality, we’re not scrambling to assess whether it’s a threat to the portfolio. We’ve already done much of the work.”
Al Clark is MLC Asset Management’s head of investment. Clark explains the Investment Futures Framework allows the team to consider the impact of unforeseen events on portfolios before they happen.
“So when the coronavirus came to light, we had already considered how something similar may play out in our investment processes,” Clark explains.
MLC’s process involves a systematic and flexible approach to reviewing a range of outcomes that may impact the portfolio’s returns. The first step is to think broadly about how a range of credible outcomes could affect the portfolio. This involves looking back through history at events and risks that have impacted financial markets. The next step is to rank scenarios in terms of how likely or unlikely they are.
For instance, it seems unlikely interest rates will change. This is due to signals from the Reserve Bank of Australia the cash is likely to remain at 0.25 per cent for the immediate term. MLC’s fund managers apply this to the decisions they make about the assets in their portfolios.
“Given it’s unlikely rates will rise anytime soon, the credibility of a hyperinflation scenario is quite low,” MLC Asset Management’s head of investment, Al Clark, says. “By contrast, in an environment in which interest rates are falling, deflation may be a concern. Either way, our methods allow us to think about both eventualities in advance.
“We can also trade off different outcomes against one another with respect to how they impact financial markets. This gives us a very robust device when it comes to setting the investment strategy. We’re not picking one scenario over another; we’re picking trade-offs,” he adds.
MLC’s Investment Futures Framework removes the need to predict financial market outcomes, which is notoriously difficult. In the case of COVID-19, the team is able to assess how pandemics have affected financial markets and economies in the past. It can apply this thinking to the current scenario, accounting for differences between the way coronavirus is behaving versus earlier diseases.
For instance, in January the world-renowned medical journal The Lancet published an article highlighting the potential for COVID-19 to be transmissible from asymptomatic cases. While this in itself didn’t guarantee the disease would become a pandemic, it did suggest the potential for widespread dissemination of the virus. So the likelihood of a pandemic was no longer just a long-tail threat.
As the pandemic has played out, uncertainties have been especially elevated given there are so many unknowns. As such, this is no time to be heroic, says McCaw. “There’s still a huge array of outcomes that could play out over the next 18 months. There are so many factors over which it’s hard to get visibility.”
These include how long the community will be required to socially distance and when and even if a vaccine and reliable therapy will be developed to combat COVID-19’s effects. Additionally, the velocity of the crisis means many of the usual data points analysts use to assess risk in investment markets are compromised or non-existent. For instance, few companies are giving earnings’ guidance right now.
“Our processes have already factored this into the way we frame scenarios, allowing us to understand how the coronavirus pandemic could impact the risk reward trade off,” says Clark. This puts the team in a position of strength to identify exposures to help position the portfolio during this time of high volatility.
“This is a situation in which it’s important to be nimble and remain liquid. We’re taking the opportunity to add risk at lower levels and take it off and take profits when risk is heightened. It’s all about taking a graduated approach,” he adds.
Clark says: “Our methods allow us to put substantial critical thought into the investment process. We’re continually assimilating more information into our scenarios, which allows them to become more refined. We can reduce risks in the portfolio and take advantage of opportunities on that basis.”
Ultimately, MLC’s approach puts the team in a better position to identify when it’s efficient to control risk and when it’s not. The result, they say, is a better outcome for investors.