- What are the risks of backward-looking stress modelling?
- Why do we believe forward-looking scenarios analysis is important?
- How has this affected our absolute return portfolios?
One of the challenges of pursuing absolute returns is constructing portfolios that work in multiple scenarios and insulate investors against extreme market downturns. A core element of this is stress scenario modelling. The established risk management practice is to evaluate portfolio performance using various historic events. However, while useful, historical stresses are not representative of all possible future eventualities. Nor do they make provision for qualitative judgement.
To overcome these issues we developed our proprietary forward-looking scenario analysis methodology. It combines opinions and judgements with quantitatively-determined relationships between market risk factors, creating more coherent scenarios. The aim is to generate the expected impact on our portfolios of a 'never-before-seen' event in a rational manner that does not simply assume history repeats itself.
To model future risk events, we first consider extreme but plausible future stresses. These may be economic, geopolitical, environmental, societal or technological; for example, a China crisis, currency war or EU break-up. Combining these inputs and applying statistical techniques, we calculate the range of expected outcomes for each asset class to construct a picture of possible outcomes for each of our multi-asset portfolios.
For example, in 2014, we modelled what a crisis in China might look like - significant economic slowdown, curtailment of debt-fuelled investment, rising wages etc. We then looked at how a number of key factors might be impacted. Among these, we estimated oil prices would fall almost 50% while the Australian dollar would lose around 15% against the US dollar.
Using the findings of this analysis and through further rigorous testing, we were able to fine tune the balance of risks in certain portfolios to handle this and other extreme but plausible scenarios.
Subsequently, amid mounting fears about decelerating growth in China and a relentless commodity market slump in 2015, several strategies we held for their long-term potential delivered out-size contributions as predicted by the scenario test. For example, slackening demand in China for commodities resulted in greater weakness in the Canadian dollar, and Korea’s reliance on exports to a China no longer so hungry for consumer goods led to a fall in the Korean won. These positions provided valuable protection in 2015, in what were extremely turbulent market conditions.
The importance of forward-looking scenario analysis in constructing absolute return portfolios is increasingly important as the global economy evolves and its internal dynamics grow ever more interconnected and complex. The world of today bears little resemblance to the one of 20, or even 10, years ago; relying solely on what has gone before risks ignoring this change. However, applying quantitative and qualitative insights based on current expectations can lead to a more robust understanding of what the future might hold.