With volatility up in many parts of the Asia-Pacific region, along with correlations across almost every asset class, portfolio managers need to be more aware of risk profiles than ever, according to Scott Hamilton, director of client services at risk specialist Axioma, a provider of risk management tools for portfolio managers.
Diversification, once a mantra of risk management, has seen its usefulness severely curtailed as global markets have been soaring and diving with increasing synchronicity.
“The drivers of risk are very common themes at the moment: this is a global phenomenon, not just one affecting Asia. It’s really the market itself that is the key distinguisher of risk,” said Hamilton.
“In a more normal volatility environment, you have situations along regional lines, country lines, along style lines or sector lines. But at the moment, when there’s such a common and pervasive cause of risk, which is predominantly euro debt with a bit of US concern thrown in, we see markets are just moving in unison,” continued Hamilton.
There is plenty of evidence of the impact of the euro crisis on Asia’s markets. In its recently published Asia Pacific ex-Japan quarterly report, Axioma observed that the active risk of a 50-stock portfolio tracking the FTSE-Asia-ex-Japan benchmark had risen by about 40 basis points in just three months.
“It’s important for investors not just to understand the drivers of risk and manage that in their own portfolios, but also to monitor correlations,” explained Hamilton. “And also to take multiple opinions on your estimates of risk and correlation; one of the things we do is to use different methodologies to construct our models, on the understanding that no risk model is ever going to be perfect.”
By developing a detailed understanding of the changing relationship between risk factors, investors can gain insights into the nature of the diversification of their investments, whether short-term or long-term, he suggests.
“The big implication of the increase in stock-stock correlation is for diversification: even if you’ve spread yourself across sectors or countries, or across small caps and large caps, in the current environment, the benefit of that is reduced significantly.”
Although spreading risk through diversification has become less effective, identifying individual alpha opportunities has also become more difficult.
“Now is not really the time to be in the stock-picking game; though it’s difficult to tell someone that if that’s their job. In terms of allocating risk to stock-picking strategies, the sensible thing to do is to understand what is driving risk, and not to take unnecessary stock-specific bets at the moment because they’re unlikely to add a lot of value,” suggested Hamilton.
“That phenomenon is really the conundrum for active investors at the moment because it’s very difficult to differentiate securities from each other, or sectors or even countries,” he added. “The increase in risk that has been seen since August is fairly consistent across global markets.”
The only exception to the rule in Asia is Japan, where now the post-disaster volatility has subsided, has gone back to marching to its own, slightly different, tune.
“Japan has always behaved quite differently to the rest of Asia in terms of investment characteristics,” explained Hamilton. “Other than after the earthquake, Japan hasn’t seen the increase in volatility that the global markets have.”
While the end of sovereign debt concerns in Europe and the US may be a long way off, the cyclical nature of risk and volatility mean that a return to more manageable risk profiles may come sooner rather than later.
“If you look long-term at charts, you see spikes and then it reverts back to some kind of base level,” pointed out Hamilton. “Almost inevitably we will see a reduction in volatility and correlation. Shorter, sharper cycles are a feature of the current market environment.”
However, even once volatility settles down, stock-picking may be on its way to becoming more and more difficult due to the increased interconnectedness of markets and the speed at which information is shared across them.
“The longer-term trend towards correlation is positive across equity markets. I don’t see any reason for that not to continue.”
Author: Gavin Blair