Risk, like beauty, is in the eye of the beholder. The first half of February surprised markets with a sudden collapse in the value of risky assets followed by a rebound.
Volatility spiked and investors in volatility exchange-traded funds, which depend on stable markets, lost their shirts. Volatility, however, is not the risk long-term investors should be worried about. The biggest risk is that of permanent losses. But it could also be thought of as the risk of forcing sub-standard returns through policy mistakes.
The UK’s ongoing debate about the appropriate investment strategy for defined benefit pension funds could be a case in point. A focus on volatility as the key measure of risk leads to the objective of risk minimisation by matching estimated liabilities with over-priced assets, thereby guaranteeing locking in losses in real terms with negative real yields on index-linked bonds.
The problem for investors is that the future looks less attractive than the past for asset markets. Boston-based asset manager GMO’s latest seven-year asset class return forecasts make for gloomy reading. Apart from cash, only emerging market equities and emerging market debt show a positive real return. And both are 1% or less. There are many who argue that GMO’s mean reversion approach may not be valid so perhaps the future is brighter than it predicts. However, emerging markets are a clear case and few would disagree with GMO’s conclusions that emerging markets are the most likely asset class to offer the best returns, even if there is disagreement over the magnitude.
The problem with emerging markets is the risk, or perhaps the perceptions of risk. Growth rates are higher than in developed countries but, apparently, so are the political risks. Yet that viewpoint could itself be the result of prejudice as much as rational thought. Risk is priced into emerging market assets while developed markets too have their share of outrageous politicians.
“We are seeing a positive shift in the intellectual framework of what constitutes true risks and what is real added value”
Understanding what constitutes true risks in more objective ways is key for all markets. That can also be turned round with the argument that what is also required are better ways of measuring true value, and that debate has already begun with the growth of ESG and impact investing.
The World Bank’s release of a report in February entitled “The Changing Wealth of Nations” represents another ground-breaking step in this direction. Promoting an analysis of the changing wealth of countries both in absolute terms and on a per head basis as the World Bank argues for, provides a forward-looking analysis of their health. It also emphasises the need for sustainability in the exploitation of natural resources.
This constitutes a positive shift in the intellectual framework of what constitutes true risks and what is real added value. Institutional investors need to question both in their own strategies.
Joseph Mariathasan, Contributing Editor