A Radical Break with the Past
”Investors are shunning risk,” wrote the Frankfurter Allgemeine newspaper in September 2005 with reference to German institutional investors’ behaviour. This comment – which was substantiated only a few months later by Union Investment’s first risk management survey – describes a familiar phenomenon: institutional investors in this country prefer low-risk investments. Safety is more important to them than investment returns. For a long time, therefore, risk management performed a mainly defensive role as far as most professional investors were concerned. The prime objective here was to avoid risk. Deliberately taking risk in order to boost returns as part of a proactive risk management strategy was simply not on the agenda. It didn’t need to be: with ten-year Bunds yielding returns of 6 per cent back then, government bonds provided a safe and lucrative haven. “No experiments” was the mantra here, echoing the slogan popularised by Konrad Adenauer during West Germany’s 1957 election campaign.
The curse of cheap money
The investment world that we see today in the wake of the financial and economic crisis is totally different. There had, of course, already been a few financial crises prior to this one. However, none of them would transform the entire investment community as fundamentally as the turmoil ensuing from the bankruptcy of Lehmans. Never before had the financial system been so severely destabilised by a number of diverse, mutually interconnected crises. The markets had to digest not just the financial and banking crisis but also the global recession and the problem of government debt, which had been exacerbated by various rescue packages. Governments and central banks responded to these multiple challenges by taking a range of measures, but first and foremost by pursuing a policy of cheap money on an unprecedented scale. In an attempt to prevent deflation and the collapse of the real economy they cut interest rates to almost zero and used the instrument of quantitative easing to flood the markets with more and more money. This ushered in a period of persistently low interest rates.
What appeared to make sense from an economic policy perspective proved to be a shock for traditional investment strategies
What appeared to make sense from an economic policy perspective proved to be a shock for traditional investment approaches. Historically low interest rates and the loss of safe havens created a new paradigm: the risk-free return – for many years the bedrock of the strategies followed by German institutional investors and a key metric used in capital markets theory – had become a return-free risk. This had dramatic consequences. It proved virtually impossible to generate the necessary returns from conventional fixed-income investments. A case in point here was life insurers and pension insurance funds. The prolonged period of low interest rates resulted in this industry getting into difficulties in its efforts to deliver the guaranteed returns it had promised. It has therefore had to gradually reduce the returns that it guarantees on new business, recently cutting them to a record low of 1.25 per cent.
A cursory glance at the changing yields on ten-year German government bonds in recent years shows the massive challenges that the current low-interest-rate environment poses for German investors’ traditional strategies, which are focused on safe fixed-income securities. Whereas these bonds were yielding an average of 4 per cent back in 2008, investors were able to obtain a yield of only 0.2 per cent on these securities in the spring of 2015. Yields on five-year Bunds at this time were actually below zero. The picture is similar for other fixed-income sectors that are also classified as low risk, such as German covered bonds, which were yielding a paltry 30 basis points over ten-year Bunds in the spring of 2015.
A re-evaluation of risk
Given these challenges, one question above all has become paramount: how can investors possibly achieve decent returns in this new market paradigm?
Risk-free comfort zones no longer exist; risk has become a permanent feature of markets
The answer to this conundrum is intimately bound up with what for many German investors is the uncomfortable realisation that risk is an inevitable part of this endeavour. Safe havens – traditionally the preferred option – are now a thing of the past. Risk-free comfort zones no longer exist; risk has become a permanent feature of markets. The significance of risk and risk management has therefore changed radically. Investors can no longer avoid risk – they have to embrace it. The challenge here is to identify the opportunities associated with risk and then exploit them in a controlled way for investment purposes. Risk management must abandon its defensive perspective and help investors to pursue a proactive opportunity management approach.
Risk management has become the principal determining factor in asset management in the post-Lehmans era and, consequently, the crucial challenge facing investors, whose preferences have changed as a result. When considering the three traditional key investment criteria of safety, liquidity and returns, investors are attaching growing importance to the last of these factors. Almost one-fifth of the institutional investors regularly polled by Union Investment over the past ten years now cite the rate of return as their generally most significant investment criterion. This is the highest proportion since the financial crisis. Similarly, investors’ risk aversion has also declined sharply. A gradual shift in attitudes is already under way.
The decade of challenges
Realigning investment strategies in an age dominated by risk is certainly no walk in the park. Events over the past ten years have placed unprecedented demands on investors. Greater pressure on returns, smaller risk budgets, unstable financial markets, global crises and an explosion of regulation – all these challenges have subjected investors to a continuous stress test. There has been no let-up, and traditional investment approaches have proved useless. New ways of thinking and the willingness to change, experiment and adapt have been required. There is no sign of any silver bullet. On the contrary: individual investment objectives and preferences coupled with a number of anomalies arising from internal and external restrictions have made it impossible to draw up a blueprint.
Risk management is opportunity management
From the perspective of a risk management strategy which is committed to exploiting opportunities and preserving capital in equal measure, however, we can identify one requirement that is crucial to the success of risk-controlled investing. We are talking here about dynamic active portfolio management. Two examples illustrate its importance. Increasing diversification is now an essential part of asset allocation. This is the only way to tap new sources of return. However, the financial crisis has highlighted the limits of widely diversified asset allocation based on static weightings. New forms of dynamic diversification are needed. Risk-based approaches to asset allocation can add value here. They introduce management strategies which – unlike Markowitz’s theory – are predicated on assumed volatilities and correlations and enable investors to continually adapt to changing market conditions.
A similar situation applies to capital preservation. This, too, poses new challenges for investors in an age of return-free risk. In the past, switching to risk-free investments in order to preserve capital meant, first and foremost, that investors had to forego additional returns. Today, retreating to the comfort of risk-free investment means foregoing any return whatsoever. This impacts on risk management. Because investors are continuously having to exploit opportunities in capital markets, their portfolios are constantly exposed to risk. They therefore need intelligent, dynamic management strategies which, on the one hand, ensure that their capital is preserved while, on the other, take advantage of their risk exposures wherever they identify upside potential as a result of changing market conditions.
In the final analysis, however, good risk management is always an individual requirement. Although strategies, methods and models can help to approach the associated challenges in a transparent and clearly structured way, they ultimately have to deliver results that meet the specific needs of the investors concerned.
About the author
Alexander Schindler, born 1957, is a member of the Board of Managing Directors at Union Asset Management Holding AG. He has also been a member of the Board of Directors at BEA Union Investment Management Limited, Hong Kong and in 2015 he became president of the European Fund and Asset Management Association (EFAMA). Prior to 2004 he performed various managerial roles at Sal. Oppenheim Jr. & Cie KGaA and at Commerzbank AG. Schindler initially completed a banking traineeship and is also a fully qualified lawyer.