Update Client Magazine for Institutional

Taking Smart Risks When Investing in Times of Financial Repression

Update Magazine - IV 2013 - Allianz Global Investors - Smart Risk

The dilemma facing investors
The current environment of financial repression is characterised by low nominal interest rates and, in some cases, negative real returns in major industrialised countries such as the USA, UK and Germany. Economists and a large number of market players believe that these low interest rates will persist, directly or indirectly, for quite some time to come. The AllianzGI RiskMonitor1 clearly supports this opinion. Of the European investors surveyed, more than 40% do not expect interest rates to come close to their historical levels again until after 2015.

This environment is posing a dilemma for investors: either they grudgingly accept the low interest rates and – in all probability – miss their earnings targets or the targets needed to fulfil their obligations, or they can increase their risk exposure in an effort to meet their targets, although such a step could involve huge potential losses if not accompanied by additional risk management.

The first option is not really a viable alternative – investors have to take action. The second option is, however, clearly fraught with challenges: in times of limited risk budgets and upcoming changes to regulatory requirements – such as Solvency II and Basel III – taking additional portfolio risks is practically impossible for many investors. Added to which, many investors are disappointed at the returns generated on the stock markets over the past ten years, which are frequently being termed the “lost decade”.

Let us assume a European investor sets himself a return target over an entire market cycle of 4.5% p.a. on average, with an annual risk budget of 5%, measured in terms of Conditional Value at Risk (CVaR). The current portfolio is allocated 30% to global equities, 40% to German government bonds, and 30% to European corporate bonds. Is this portfolio capable of meeting the specified investment targets in terms of risk and return?

A simulation using economic capital market scenarios very quickly demonstrates that this portfolio will very likely not meet the targets. Both the return and risk targets will be missed. Consequently, the objective must be to raise the return potential, while at the same time lowering the risk potential. Our 4-point plan aims to resolve this supposed contradiction.

The solution: our 4-point “smart risk-taking” plan
Chart 01 shows an overview of the 4-point plan. The first two points – “Increased allocation to promising investments” and “Alpha” – serve to align the portfolio, particularly in terms of return. The points focusing on risk – “Diversification” and “Risk management” – ensure adherence to the available overall risk budget. The individual steps in detail:

“The objective must be to raise the return potential while at the same time lowering the risk potential.”

“Alternative approaches frequently involve extremely simplified attempts to perpetuate historical returns into the future, whereas the strength of our methodology lies in explicitly analysing meaningful future developments based on the starting point of current data.”

Forward-looking analyses are conducted using simulated scenarios based on the risklab Economic Scenario Generator. This approach to consistently mapping trends in economic variables has been proven in practice, and we have been continuously improving it for more than 15 years. Stochastic processes are used to derive realistic possible performance figures for the coming years, based on the current levels of the relevant variables – such as the inflation rate or level of interest rates in each case.

Alternative approaches frequently involve extremely simplified attempts to perpetuate historical returns into the future, whereas the strength of our methodology lies in explicitly analysing meaningful future developments based on the starting point of current data. Purely historical observation makes little sense, especially with regard to interest rates, as there is absolutely no room left to lower interest rates to the same extent witnessed in the past.

The resulting forward-looking inflation, interest rate, spread and risk premium simulations are used to derive return spreads for the asset classes and/or underlying benchmarks under observation. This approach enables the derivation, not just of consistently expected total returns, but also of risk variables, over various periods of time – for both individual asset classes and in an overall portfolio context.

  1. The first step involves increasing average exposure to promising investments in order to enable the required return target to be met. This step produces a considerable increase in the expected return, but at the expense of risk; i.e. the risk exposure in the overall portfolio increases. In current capital market conditions, this “re-risking” is absolutely essential for most investors. When asked which risks will most likely be rewarded in future, the investors surveyed during the Risk Monitor process prefer stock market risks, followed by credit risks.
  2. The second step in the 4-point plan involves adding sustainable sources of Alpha with little or no correlation, in order to increase return potential without drawing down much of the risk budget. This further increases the expected return – bringing the respective target return a little closer without significantly affecting the total portfolio risk. Active investment strategies are key contributors to returns, especially when expectations in respect of market returns on classic and/or traditional investments are low.

  1. One classic step in portfolio structuring is to diversify the portfolio in terms of both asset classes and regions, with particular focus on interdependencies, and thus diversification potential. Portfolio diversification is, moreover, improved by adding real assets, such as property or investments in renewable energies. At the same time, the associated direct or indirect sensitivity of the assets to inflation can provide at least some protection against inflation. The result is a more efficient portfolio with less risk potential, in spite of the identical expected return.
  2. Last but not least, an investment strategy in today’s environment should also include a risk management approach to limiting losses and protecting risk capital. As the Allianz Global Investors Risk Monitor shows, this opinion is shared by some 2/3 of the investors surveyed. The goal in this case must be to significantly reduce participation in market losses, without sacrificing too much upswing potential. Dynamically adjusting the portfolio allocation to the risk budget or market changes generates particular added value in today’s market conditions, which are characterized by shifts between risk appetite and risk aversion (“risk on/risk off”). Dynamic risk management significantly reduces the risk, while the expected return remains constant over the medium term.

Chart 02 illustrates the individual effects of each measure in terms of risk and return. On the return side, increasing the allocation of promising investments, such as equities, produces the greatest effect. On the risk side, the most significant improvement – in terms of risk reduction – comes from incorporating dynamic total risk management. Smaller positive effects are produced on the return side by adding the respective sources of Alpha, and on the risk side by employing the classic tool of risk reduction – diversification.

“Dynamic risk management significantly reduces the risk, while the expected return remains constant over the medium term.”

The 4-point plan in practical use
If the 4-point plan is applied to the investment situation described at the beginning of this article – average return target of 4.5% p. a., annual risk budget of 5% – it produces the result shown in Chart 03.

By replacing government and corporate bonds with higher-yielding investments, by adding active sources of Alpha, by broadly diversifying across traditional and alternative investments, and by employing dynamic risk management with pro- and countercyclical elements, the optimised concept now forecasts an expected return of 4.5% p.a. on average over a full market cycle. But it is not just the expected return that has improved. The risk profile has also become more attractive, mainly as a result of the dynamic risk management, which can significantly reduce risk exposure in negative market phases, and raise it in positive phases. Together, the individual components also ensure adherence to the specified potential loss of 5%, measured in terms of 95% CVaR.

In an environment of financial repression, low interest rates force investors to review their respective portfolio strategies and – generally – to take action, given that neither the risk targets nor the return targets can be easily met in today’s market conditions. Investors should therefore revisit their overall investment strategies, and increase the optimisation potential. The 4-point “smart risktaking” plan that we have developed aims to help you come closer to your risk and return objectives when planning your investments. With the aid of the Allianz Global Investors Portfolio Health Check®, we would be happy to tailor your allocation for the future.

[1] Global survey by Allianz Global Investors among 400 institutional investors.