The credit crunch has been the catalyst for sweeping changes which are moving the world towards a radically changed economic environment. Investment company, PIMCO, has coined the term for the future environment, the ‘new normal’, and outlines key characteristics of this new state as being increasing deleveraging, a thorough re-examination of financial regulation, the introduction of new legislation and a slowdown in globalisation. The new economic environment is going to require both single and multi managers to manage client portfolios very differently.
The new normal will also have a definite impact on financial markets. Since the crunch, returns have been flatter and could continue to be so for the foreseeable future; and the range of possible outcomes from investments is also flatter. We expect tails – the ‘extreme’ outlying events, either positive or negative – to be fatter. In order to deliver value to investors, it is therefore critical to become highly focused and to adapt to the new circumstances.
The four strongest responses which money managers should have to the new normal environment are examined below:
1. Get the tails right
Achieving an investor’s end goals can be very difficult. It is critical to get the tails right when investing by, for instance, adopting tail-hedging strategies to protect your portfolio against macroeconomic risks. Tail risk refers to those big, hard-to-predict events that can lead to huge portfolio losses, like the credit crunch, for which money managers were completely unprepared. It is therefore crucial to have strategies in place to hedge a portfolio against such an event. The aim of ensuring the tails are timed right is for money managers to avoid selling when the market declines, and to ensure they are in a position to sell when the market rallies.
2. Rebalance more often
Pure strategic asset allocation will not necessarily deliver results in the new climate. Investments need to be actively rebalanced more often – either upweighted or downweighted as market conditions dictate. Managers need to keep their investment portfolios extremely nimble so that when the market declines, they are able to quickly buy more exposure and when it rallies, they can easily sell exposure.
3. Be very careful of leverage
Leverage + volatility = lethal! Leveraging an investment can do a massive amount of harm in times of volatility. Vehicles which rely heavily on leveraging – such hedge funds – can be knocked out quickly in times of volatility. It is best, therefore, for managers to limit their exposure to leveraging so that volatility does not have too significant an impact on portfolios.
4. Understand all the risks and opportunities in a portfolio
Some fund managers don’t fully understand the risks inherent in the financial markets or how truly to diversify; for example, while it is very important to diversify by asset class, this is not enough in the current climate. There are other risk factors in the bond, property or equity markets which have to be taken into account. For instance, shares such as Standard Bank or Truworths are directly impacted by interest rates so this risk should be borne in mind. Equally, it is an opportunity. In the new environment, these risks are enhanced and should be understood by money managers.