New study shows investors face risk-return conundrum

September 11, 2017 08:00
In a survey of 750 institutional investors, 44 per cent say geopolitics represent a major risk to investment performance. Photo: Reuters

While financial markets have never operated in a vacuum, geopolitics now appear to be having a greater impact on how investors are behaving than at any other point in recent memory.

This is perhaps no surprise, given the tensions between the US and North Korea, and political turmoil in Washington. But our latest study reveals the extent of this anxiety, showing that geopolitical tensions are the number one concern for global institutional investors.

Geopolitics in the spotlight

Conducted annually, our RiskMonitor Survey explores investor attitudes toward risk, portfolio construction and asset allocation. This year’s study canvassed the views of more than 750 institutional investors across North America, Europe and Asia-Pacific.

Of the investors surveyed, 44 per cent say that geopolitics represent a major risk to investment performance – ahead of a global economic slowdown (41 per cent) and rising interest rates (32 per cent).

Event risk and equity market risk have also risen sharply up institutional investors’ agendas over the past 12 months: 

-- More than nine in 10 investors (91 per cent) see event risk as a threat compared with only three-quarters in 2016.

-- Equity market risk was a concern for a similar number of respondents, weighing on the minds of 90 per cent of investors (2016: 77 per cent).

-- Perhaps most tellingly, only 26 per cent of investors are ruling out a tail-risk event in the next 12 months. Conversely, 45 per cent of investors believe such an event is likely to happen – a figure that has risen substantially in the past year (2016: 37 per cent).

On a positive note, investors are feeling more confident about the financial system as a whole: Only one in 20 voice concerns about counterparty risk, compared with one in five in 2015. This suggests that regulation and other factors are helping to restore a sense of confidence to markets.

Renewed emphasis on risk management

On the other hand, geopolitical concerns are prompting investors to take action: Nearly three out of five (59 per cent) say that recent political events have led to an increased emphasis on risk management in their institutions.

As investors aim to balance risk and return, active management is coming to the fore: Two-thirds (65 per cent) of investors say that actively managed investments play an important role in their portfolios in the current market environment.

But the prevailing market conditions continue to test traditional approaches to risk management. Indeed, our findings show that investors face a risk-return conundrum as they seek to optimize the risk-return trade-off in uncertain markets.

This dilemma is reflected in the number of investors who are trimming their return expectations for the coming year: More than half (51 per cent) have lowered their return targets despite a strong recent performance by equity markets, and 53 per cent are willing to sacrifice upside potential to get tail-risk protection.

Call for new risk-management strategies

As they struggle to reconcile the risk-return conundrum, investors see shortcomings in existing risk-management approaches. Nearly three out of five (58 per cent) are looking for new portfolio strategies that balance the risk-return trade-off.

For now, a majority rely on traditional risk-management techniques – including diversification by asset class (68 per cent) or geography (66 per cent). Far fewer respondents invest in strategies such as direct hedging (29 per cent), currency overlay (29 per cent) or tail-risk hedging (26 per cent).

What’s more, only 47 per cent think that diversification across traditional asset classes offers effective protection from tail-risk events. Instead, alternative asset classes are garnering more attention, with 69 per cent of respondents saying that alternative investments do their job and fulfil their role in a portfolio effectively.

Risk leaders emerge

Encouragingly, as investors look beyond traditional approaches, a group of “risk leaders” is emerging. Comprising around one-fifth of respondents, they clearly have experience getting ahead of the risk-return challenge:

1. They make risk management an integral part of their investment processes.

2.These investors also have strong risk cultures, led by senior management.

3. They are more likely than other investors to invest in alternatives for diversification.

4. Crucially, these investors are more confident in their ability to achieve their return expectations for the year.

Ultimately, even as investors wonder whether markets have priced in today’s geopolitical risks, they also know the importance of taking risk to earn returns.

Managing risk today means reacting quickly to any recalibration of assets, and capturing opportunities while optimizing downside protection. Our research shows that more investors are exploring new, non-traditional ways to approach risks, which may give some implications to asset managers.

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As Global Strategist at Allianz Global Investors, Neil Dwane is responsible for presenting strategic house views and overseeing the Economics and Strategy Research teams.