Research and Insights

The future belongs to smarter risk managers

| 15 October 2015

Speaking at the Sanlam Investments Institutional Insights conference in Johannesburg last month, Roland Rousseau, head of the Barclays Africa Risk Strategy Group, ventured to say that asset managers may sometimes overrate their skill in terms of beating benchmarks, outperforming their peers or winning industry awards. “Higher returns do not necessarily equate with greater skill. It is possible to beat the benchmark without actually demonstrating any skill”. In attempting to prove their “skill”, both active and passive managers may take on excessive risk, thereby introducing “moral hazard” into pension fund investment portfolios.

Rousseau suggested that the way forward was for the industry to look towards adopting a more pragmatic “risk mindset”. Jason Liddle of Satrix added to the debate by saying that smart beta may be the solution.

Is risk the new benchmark?

“Since asset managers cannot all outperform in terms of returns, perhaps the new industry benchmark should be risk”, challenged Rousseau. How many asset managers can successfully outperform the risks they have taken? Because of extreme volatility, returns alone are not always a true measure of skill. In a future-fit world, we should be talking about risk allocation, not asset allocation. In a crisis, all assets fall. The winners will be the ones who most accurately manage that risk.”

Rousseau said traditional methods of assessing an asset manager’s skill, through past performance and track record, may also be fundamentally at odds with the fiduciary requirements of a pension fund — which must value wealth preservation equally with wealth creation. Correctly assessing the “risk cycle” of investor sentiment was therefore more important than tailoring a portfolio to current economic conditions, he said.

So what is the solution?

Rousseau said the answer did not necessarily lie solely in passive investing. Although being less costly to invest in, even the most carefully designed index trackers contained intrinsic risks themselves, because of their high concentration of stocks and implied lack of diversification.

Rousseau said the solution could be found in a customised process of “dynamic risk control”, which entailed blending active management (with or without derivative instruments) in tandem with passive (index) strategies that first and foremost sought to mitigate risk.

The middle ground is the fertile ground

Jason Liddle, CIO at Satrix, agrees. Globally, the debate has moved on from active versus passive to how these strategies can be combined to assist an investor in reaching their objectives. It is important to understand that returns are merely the symptom of how well the risks (the cause) have been applied and managed in any portfolio of assets.

By asking some simple questions, like what is driving a portfolio’s return, some interesting answers and valuable insights emerge when a portfolio’s risks are unpacked. For example, if your active equity manager provides a 20% return in a given period, be curious as to how much of that return was driven by the market, systematic risk factors and how much relates directly to a manager’s skill and value add.

The industry has sharpened its pencil on this phenomenon called alpha over the years and what they found was that it consisted of common, systematically-generated risk factors. An active manager’s process would systematically gravitate to portfolios with a certain risk character, be it low price earnings (value) or a higher return on equity (quality) or mid and small caps (size) as a result of their philosophy and how they filter, analyse and construct their portfolio.

The passive industry is able to extract a similar formula and offer products that provide a comparable ‘active’ experience. Products of this ilk have been commonly referred to as ‘smart beta’, smarter indexing options which can harvest a product by capturing specific equity risk characteristics like dividend yield, size, value, momentum or quality. These risk characteristics have shown a return premium above that of the broad market trend.

This new thinking builds more diversified, more risk-smart portfolios, concludes Liddle.

Watch the related video here.

Satrix Managers (RF) (Pty) Ltd is an authorised Financial Services Provider a registered and approved Manager of Collective Investment Schemes (CIS) in Securities in terms of the Collective Investment Schemes Control Act, 45 of 2002.

Although all reasonable steps have been taken to ensure the information on this article is accurate, Satrix Managers (RF) (Pty) Ltd (“Satrix”) does not accept any responsibility for any claim, damages, loss or expense; however it arises, out of or in connection with the information. No member of Sanlam gives any representation, warranty or undertaking, nor accepts any responsibility or liability as to the accuracy of any of this information. The information to follow does not constitute financial advice as contemplated in terms of the Financial Advisory and Intermediary Services Act. Use or rely on this information at your own risk. Independent professional financial advice should always be sought before making an investment decision.

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