Fund houses must devote more time and resources to analysing tail risks of past events such as the Covid pandemic and Brexit, agreed panellists at FundForum in Monaco
Before looking at the future, investment houses must learn the lessons of the past. This key premise underlying today’s complex asset allocation decisions was firmly laid down by panel chairman Amin Rajan, CEO of the Create-Research consultancy, during an investor discussion at the fund industry’s early summer summit in Monaco.
The key point which many private banks and investment firms have missed, said Mr Rajan in a conversation with his panellists, has been accurate analysis of tail risks including the Covid-19 pandemic, Russia’s invasion of Ukraine and consequent inflationary spiral.
Fund houses and wealth managers listening to the discussion at the IMPower FundForum event at the end of June were acutely conscious that their predecessors had also failed to account for market consequences of both the Global Financial Crisis of 2008 and the UK’s narrow Brexit vote to leave the European Union in 2016.
“We obviously have been through a period, if we think back [across] the last 10 to 15 years, where tail risks have always been part of the overall asset allocation consideration,” said Sonja Laud, chief investment officer of Legal & General Investment Management (LGIM), overseeing £1.2tn ($1.5tn) of investors’ assets.
“But we've probably never spent a sufficient amount of time in terms of understanding and pricing them into our asset allocation considerations, and now we've had quite a few over the past three years, if you consider the pandemic and then particularly the war in Europe.”
More resources
Investment houses must deploy more resources in this detailed analysis, as risks continue to increase, she suggested. “This is clearly something we need to spend more time on in future because we will look at a world that is shifting considerably.”
Part of this task involves identifying major “inflection points” in economies and markets, including a recent shift in the interest rate cycle, which market participants still underestimate. Surveying the packed, youthful audience of investment professionals, Ms Laud pointedly asked: “Look around at your investment teams – how many of you have never seen interest rates above zero? I bet it’s quite a few.”
The poor level of analysis at top institutions was highlighted by Peter Branner, chief investment officer at Abrdn, responsible for £500bn ($640bn) in client assets. “We are extremely bad at forecasting,” he said, struggling to “see the turn” and judge the peaks, referring to the mass industry-wide calculation at the end of 2022 that equity markets would plummet, which ended up “pretty wrong”.
The next challenge, he said, lies in identifying the “technology shift which will create a lot of opportunities” for investment houses able to pick industry sectors adapting to transformation.
These hurdles sit alongside diversification difficulties of a new world where bonds and equities often move in tandem. “Diversification only works until it doesn’t,” said Mr Branner, drawing attention to the thorny issue of liquidity, which investors in the burgeoning private assets class may suffer from if “forced selling” becomes necessary in a crisis mirroring 2008.
Modern portfolio theory
Key to the discussion was the legacy left by Nobel Prize winning economist and market scientist Harry Markowitz, inventor of modern portfolio theory at the University of Chicago in the 1950s, who died several days before the forum.
Significantly, many investment houses and most private banks still base their asset allocation models on Mr Markowitz’s theories, which suggest there is an optimal allocation between bonds and equities for each investment portfolio. While panelists praised the simplicity of the model and its central assumption that increased risk generates portfolio returns, Mr Rajan questioned the theory’s validity and its continued centrality in portfolio management.
“His framework was so elegant, that it made investing seem a little bit more simple than it really was in those days,” said Mr Rajan, drawing the room’s attention to the fact that the model looked only at one specific time period. “That kind of world didn’t exist then and it certainly doesn’t exist now.”
While Mr Rajan revealed he has “received death threats” from portfolio theory purists since authoring a paper questioning the model’s assumptions, he bears no ill will to the financial fundamentalists.
“I think it is a starting point in investment theory that was probably as good as we could have had. And his idea about the efficiency frontier was probably a big contribution to investment theory. But is it very relevant today? I don't think so. That's my personal view.”
