It is during periods of uncertainty that risk management must be at its tightest and a high priority for all investors. But it would be simplistic to conclude this is the only lesson to be learned from the ongoing financial crisis.
Crises remind us of the existence of certain risks. Liquidity risk, often overlooked or more accurately associated with a very low risk premium, will certainly be etched into our memories for a long time. The flight to liquidity resulted in a massive drop in the value of assets, sometimes unrelated to their intrinsic risk. To say the least, the vast and often unselective widening of all corporate spreads did not perfectly reflect the default risk of the different issuers. Even more representative, the financial solidity of inflation-linked government bonds has never been questioned. What caused them to lose value was the sudden rise in the compensation demanded by the market for abandoning the possibility of selling the assets at any time.
The flight to quality or liquidity has also had an influence on the correlation between the asset classes. By penalising indistinctively and simultaneously all sources of risk, it tends to increase correlation between all assets perceived as risky, thus diminishing dramatically the protection that diversification across various type of investments could bring. This is critical for every investor because it affects the portfolio construction process that relies on those diversification properties. The hedge fund universe brings one of the best illustrations of this effect. Although very diverse in terms of investment strategies and asset classes, hedge fund returns show a strong increase in correlation within and across categories in times of crisis. This fact underlines the dramatic decrease during tumultuous times of the diversification benefits expected from investment strategies that would diversify each other in normal periods.
Lessons can also be learned from market behavior for return forecast purposes. During high volatility periods, asset valuation based on fundamentals has proved less effective. Uncertainty about the fundamental variables themselves can explain why already low prices are sent even lower by the increase in risk premia. But there is another reason why the fundamental indicators become less efficient: many investors have to act without taking them into account because they need to manage internal or regulatory risk limits, investment constraints and all sorts of short-term considerations.
Stepping back a bit, forecasting models based on fundamentals have proven to be working on average for a very long time. In other words, to buy stocks of companies with attractive perspectives and reasonable prices is a winning strategy in the long run. However, this approach wins if the market is primarily driven by long-term considerations or by the almost mythical long-term investor. And this statement can certainly be questioned during shorter periods. Typically, in tumultuous times, short-term constraints can become predominant and damage the forecasting power of fundamental-based models. As the priority becomes the short term, investors can end up selling assets they find cheap to reduce their instantaneous risk or to protect what can be protected of annual results. To summarise, the long-term behavior of the market is an average of periods driven by fundamentals and times when priority is given to short-term risk control.
What type of conclusion could we draw from this observation? Although, the statement could be popular in the aftermath of the crisis, I don’t believe that rationality is totally foreign to financial markets. I am convinced that to rely on fundamentals to price financial assets is still a sound approach for asset managers. But what we know is that the forecasting power of theoretical valuations depend on the context, and that any sign of predictability of this context is very valuable. So sure, anyone who is a long-term investor does not need to bother with this and could stick to the positions waiting for the average to materialise. But for most of us, investors who have to report annual results to boards of directors or asset managers needing to explain annual or quarterly returns, patience may not be enough, and factoring contextual variables in the short run is very helpful.
Pierre Sequier is chief executive officer at Sinopia, HSBC Global Asset Management.
