Risk in a wrapper

Earlier this year, the CFA Institute’s annual conference in Edinburgh, Scotland featured two speakers addressing two very different, but ultimately related types of risk.

Unrewarding risks

The most critical component of portfolio risk management is identifying and eliminating unrewarding risk, according to Guy Stern, investment director and head of multi-asset fund management at Standard Life Investments.

“There’s a tendency to focus heavily on equity risk, but there are in fact a number of other very big risks, including inflation and interest rate risk,” he said. It’s crucial to quantify interest rate, equity, inflation, credit and other risk factors affecting the performance of your portfolio.

“What you very quickly see is the biggest risk in a portfolio isn’t the exposure to equities,” he said. “The biggest risks are really how much interest rates might be, or how much inflation might affect your portfolio. You’re not going to get paid for taking those risks, and taking a standard multi-asset or balanced or mixed benchmark doesn’t address this particular problem.”

Once the various risks in the portfolio are identified, the asset manager must determine which of these risks can generate a reward. Risks you can’t be rewarded for should be hedged away.

“Hedging away those unrewarding risks gives you a much bigger risk budget, which you can use for seeking positive returns in the portfolio and improving the overall outcome,” he said.

Buying inflation swaps is a good way of dealing with inflation risk, for example.

Eliminating all your exposure to unrewarding risks can reduce the overall risk exposure of the portfolio by as much as a third—without altering return parameters, he said.

But if generating equity-like returns is your goal, “the sum of all of your risks, without considering diversification, probably needs to be about equity-like in nature,” he noted.

“You need to take enough risk to generate that kind of return. The two things I would always counsel is that you want to make sure you’ve got enough risk, and that you measure how much of that risk you can diversify away. Diversifying [risk] away simply means finding other rewarding strategies or asset classes so that the overall level of risk becomes much more manageable.”

Political risks

Pippa Malmgren, president and founder of Canonbury Group and Principalis Asset Management, put the spotlight on the risks associated with the major political upheavals that have become a defining feature of today’s global landscape.

These risks “are not tangential for investors—people cannot go forward thinking, ‘Well, that was a black swan, we just couldn’t have anticipated it.'” In Malmgren’s view, major geopolitical events like the unrest in the Middle East can be anticipated.

Inflation, she argues, is a key indicator of future political unrest.

Inflation is on the rise in emerging markets, where upward of 50% of workers’ salaries are spent on food and energy. When the pain from inflation passes a population’s breaking point, governments should expect mass unrest, Malmgren said.

She emphasized the importance of gauging true inflation rates, rather than relying on the dubious figures governments churn out. For example, the Chinese government is reporting 5% inflation, when the real number is a lot closer to 10%. The authorities in India claim they’re running around 16% inflation, but on staple foods the actual rate is more like a staggering 100% a year, she said.

These gaps between the official data and the facts on the ground are “materially important,” she stressed, adding that the Chinese are “exceptionally worried” about inflation because throughout the country’s history, it has been a catalyst for dramatic political upheavals.

“Inflation becomes the spark, the thing that makes people conscious they’re being squeezed, and people ask themselves, ‘What can I do about it?'”

In the Middle East, where there’s a sense that rulers have confiscated the national wealth, the answer has been regime change.

Malmgren noted that in a number of Asian countries, wage hikes have been used in an attempt to quell unrest. She warned, however, that this may not cut it: a doubling of the minimum wage in Bangladesh was followed by three days of intense rioting. Malmgren added that “there may be something to the argument that Vietnam could be the next Tunisia.”

The ideological component of these upheavals usually hits the stage in the second act, she argued. Economic grievances provide the impetus for the initial burst of unrest, which then coalesces around and morphs into explicitly ideological causes. “That’s when the rubber hits the road, and this is what we’re seeing in emerging markets.”

The unrest in Egypt is a good example of this pattern at work. In its early stages the outlawed Muslim Brotherhood was operating largely out of view. The Brotherhood now occupies center stage and has to a considerable degree succeeded at moving its hardline ideological objectives onto the post-Mubarak agenda.

Malmgren noted that when people find themselves in the middle of these kinds of upheavals, or believe major unrest is in the offing, they’re bound to produces less, which translates into higher prices coming out of emerging markets. This, combined with ballooning shipping costs and the often dreadful quality of emerging market goods, is leading to a return of manufacturing to the West, she observed.

Sometimes it’s the little things that can tip you off to inflationary trends that might signal major pressures, Malmgren suggested. Finding your Snickers bar doesn’t really satisfy the way it used to? Wondering why your Caramilk bar is missing two squares? It’s because skyrocketing cocoa and sugar prices have forced manufacturers to sell smaller bars at the same price to maintain their margins.

Waistlines the world over may be grateful for the smaller portions, but the factors leading to such changes are often symptomatic of broader and highly troubling trends, Malmgren said.