At a time when bearishness is spreading like wildfire through the markets, portfolio and market risk analysis is essential, says Eoin Murray, head of the Investment Office at Hermes Investment Management.
After considering five key risk categories, it is apparent to us that markets are at a critical point, with the stability of correlations and heightened event risk being headline concerns.
Troubled times: Global markets began this year by bucking a trend. Usually buoyed by the so-called ‘January effect’, this time markets around the world slid on growing concerns about China’s economy, the oil price and the future path of interest rates. Investors are anxious and fear that this rout, following the volatility of last August, marks the start of a bear market.
In this environment, it is vital for investors to be aware of the risk in their portfolios, as the distributions of asset returns are likely to change.
Five key measures of risk: Within the Hermes Investment Office, we consider at least five forms of risk, with several indices contributing to our view of each. These are as follows:
• Volatility has undoubtedly increased given recent events. Even before the turmoil began, key indices showed that volatility was rising in equity and commodity markets and that it was only falling among currencies. Forward-looking indices indicate that investors should expect more frequent spikes in volatility. While these surges create uncertainty, they could also present opportunities for active investors to take advantage of rapidly changing prices.
• Correlation risk can often be an imperfect measure, as it reflects either a long or short-term view, rather than a nuanced combination of the two. It is also problematic during periods of market stress of the kind being experienced now, in which correlation levels can change rapidly before reverting at a later date. One way to address this is to use the standard deviation of the correlations between asset classes, which shows the stability and, importantly, the historical reliability of correlations. This measure indicates that although correlation risk was relatively subdued throughout 2015, it appears to be very unstable and is likely to change rapidly as we progress into 2016.
• Stretch risk reflects the likelihood of a ‘snapback’ for an asset class, where medium-term trends have masked longer term risks and volatility levels. Commodities are a good example of this, as relatively gradual falls in prices over the last couple of years have lowered volatility and failed to reflect the likelihood of an acute rise or fall in prices. This pattern has been evident in several asset classes amid an oscillating macroeconomic environment, making us extremely wary of mean reversion. Relative valuations between certain asset classes also appear stretched and should be monitored closely.