5 March 2020 – As global markets dramatically displayed in late February, the lack of a risk-adjusted investment positioning process can be quite costly to money managers and individual investors alike. During the week of February 24th, the S&P500 equity index fell by 11.5%: this was its biggest weekly drop since the 2008 Global Financial Crisis and only its fifth double-digit decline since 1940.
The expected disruption of a COVID-19 pandemic to global supply chain and productivity hit the projections of global corporate profits, with investment strategists cutting substantially their 2020 profit growth forecasts. Concerns about the expected impact quickly escalated and fear replaced complacency, also reflected in the benchmark 10-Year US Treasury yield which breached the 1.30% benchmark for the first time ever.
Markets soon started discounting a coordinated intervention by the major Central Banks, in the form of monetary and/or fiscal policy responses; notably, the US stock futures market implied a rate cut of 0.50% by the Federal Reserve in March (which actually occurred on March 3rd).
What distinguishes that week’s price action is not simply the size of its correction but also its speed, i.e. the short amount of time it took for the market to reach that level of correction. There are only four other events that have produced larger six-day moves, in August 2011, October 2008, July 2002 and October 1987.
This recent incident clearly displays what highly esteemed traders and star portfolio managers have been preaching for decades: You cannot manage your returns, but you can manage your risks. Such violent reversals (admittedly from high asset valuation levels) do not allow investors to re-position their portfolios in a timely manner or allow them to profit, unless they are already invested in the direction of the reversal.
Risk measurement cannot be put on ice until an investor decides to make a use of it. Extreme market events are evidently more frequent and violent than commonly thought of and their effect on portfolio performance should be diligently and continuously assessed.
- Stress-testing methodologies allow us to gauge a portfolio’s behavior in different hypothetical scenarios, by determining how stressed values of given factors affect a portfolio’s ability to deal with unexpected market events, for a wide spectrum of factor shocks.
The KlarityRisk platform enables its user to perform tailored stress-tests based on the portfolio’s specific requirements and also simulate the change of portfolio values against a wide selection of major historical crises (economic, market, geopolitical).
- Contribution analysis allows us to view a portfolio’s risk decomposition, thus effectively identify ongoing imbalances between position weights and risk.
The KlarityRisk platform enables its user to decompose risk by asset class, country, industry and individual security, thus determining the risk-adjusted performance figures by each individual segment of the portfolio.
Considering the current low interest rate environment, retirement and insurance portfolios could also use stress-testing and risk contribution analysis to ensure that extraordinary events would still allow them to maintain efficient stream of cash flows for meeting their recurring payout liabilities.
The use of a comprehensive risk management platform that is operationally integrated to one’s middle and back office systems, allows for a seamless investment process with no compatibility or cost implementation and maintenance issues.
FINVENT Software Solutions is for the last 20 years the sole SS&C Advent distributor in the world, providing Advent software applications and custom engineering services to financial institutions in several European and African countries. Our award-winning KlarityRisk platform specializes in investment risk analytics and fixed income performance attribution reporting and it is natively integrated with SS&C Advent APX.
Posted by Yannis Sardis, Director, Finvent Software Solutions.