Looking back, history is a valuable place to find answers, says Jason Liddle, CIO of Satrix Managers (a wholly-owned subsidiary of Sanlam Investments).
The 2008 global financial crisis, like many before it, has led many investors, investment practitioners, risk managers and policy makers to rethink and re-evaluate their approaches to investing and the capital markets.
In examining past market crashes, our aim is to empower trustees with the knowledge to engage with consultants and investment managers on the lessons learned, and various practical measures that can be leveraged for future market shocks.
Invariably, says Liddle, if you were wondering how and why our capital market and banking system has its current design, the answer does not lie in the careful and calculated plans in calm times but rather the frantic cobbling together of reforms and quick fixes post a crisis.
Very often those ‘quick fixes’ become permanent structures that get left in place, and then we tend to repeat the same mistakes that cause market crashes over and over.
Many investors have taken on losses well in excess of their expectations and those that missed the subsequent rebound in risky assets resulted in significant further underperformance.
In the wake of the major financial crises experienced over the last two centuries, higher unemployment, debt and real economic slowdowns have been the result. One of the first things we recognise is that the reforms undertaken to remedy the causes of financial crises are very much “post-crisis sticking plasters that become a permanent feature of the system” (source: The Economist).
When we look at our capital markets and financial systems today, their evolution and ultimate structure have been undeniably shaped by these crises. Financial markets will in all likelihood experience another period of severe stress in the future. How do we approach our investment strategy in the face of this looming risk?
Seven practical lessons we can learn from the past:
1. We should always start out with a healthy dose of good old “common sense”. The old adage: “If it sounds too good to be true, it probably is” has strong bearing here and we should at all times attempt to fundamentally understand every investment strategy that is considered. Keeping it simple and avoiding unnecessary complexity tends to be more effective over the long term. If you can’t understand an investment strategy, rather avoid it altogether.
2. The importance of stress testing: Understanding what could go wrong and how it could impact your members’ long-term wealth and retirement assets is imperative. “Nenegate 9/12” took many by surprise and cost many retirement funds dearly. Do we have any idea what the impact of a “Nenegate 2.0” or a ratings downgrade, would have on our member’s assets? Here, examining the much-neglected practice of stress testing is key. The process would involve determining the scope of the problem, understanding the catalysts, developing a scenario plan, measuring the transmission of the ‘shock’ and making appropriate portfolio adjustments. When we fully understand the drivers behind these market shocks, it enables better decision making.
3. What are the significant drivers of risk in your portfolio? As asset managers, we have become so obsessed by returns that we have underestimated the underlying risks. Returns are often merely the symptom of all the risks sitting inside the portfolios. It is therefore important to understand the nature and sources of risk as a critical part of the investment review process. Financial crises tend to unmask overlooked risks and hazards that were there all along. For example, equity risk concentration is significant in any balanced fund and it is vital to relook equity investment strategies given the advent of factors and smart beta.
4. Liquidity takes on paramount importance especially during a financial market crash. It is the first thing that takes a knock in a crisis. Many investors have been burned by illiquid exposure to strategies that had done well prior to a crash. With the advent of alternative assets in the form of real assets (direct property and infrastructure), private equity, Africa and hedge funds it is equally important to understand both their benefits and illiquidity character. What will be the impact on liquidity during a market crash and during times of extreme market stress? This is where liquid passive portfolios can often help ease the impact by bringing down the overall risk of the portfolio with minimal market impact.
5. Watch for those behavioural biases (e.g.: risk aversion): We are often more risk averse than we think we are. We all are ‘prey’ to our emotions and managing them during times of stress is difficult. We feel the pain of loss more than we feel the joy of an equal gain, so behaviourally; we are more likely to make poor decisions in our attempts to avoid losses.
6. It is time in the market that counts and not ‘timing the markets’: Maintaining discipline and sticking to your investment strategy is vital. While financial market crashes have become more frequent these days, capital markets have also recovered very quickly. Faced with the very long term over which we need our assets to ‘work for us’, changing strategy too often can have the opposite effect to what is intended. Measured exposure to different asset classes is also important.
7. Stick to a robust process and sound governance principles. This will always stand you in good stead. Investors need to perform their own due diligence (or engage diligent consultants) and ask the right questions about the riskiness of the fund strategies they are purchasing. Fund and other ratings can be useful but are not substitutes for ‘kicking the tyres’ yourself.