In bullish times many investors share
the view that markets seem riskless. In early 2007, credit spreads were tight
and equity markets roared as China
drove Australia
through what seemed to be a commodities super-cycle.
Upbeat commentaries
outweighed the sober views of market doomsayers, and while quantitative
value-at-risk (VaR) models recorded early subprime shocks, they were overlooked
by the herd. Occasional press articles advised investors to keep dancing but to
stay within sight of the exit. Alan Laubsch, who heads RiskMetrics Labs Asia, says the first warning preceding the credit crisis
was a 300 per cent spike in volatility, between December 12 and 21 in 2006, on
a VaR forecast model tracking the 2006-1 AAA tranche of securitised subprime mortgages
on the ABX index.
Two months later, on February 23, 2007, the model recorded
another tremor: after HSBC sacked its head of US mortgage lending on the back of
losses totalling US$10.5 billion, volatility leapt to 350 per cent, and spreads
on the 2006-1 AAA vintage rose from 11 to 30.8 bps. Even after this alarming
signal, it was not too late to hedge, Laubsch says. Spreads contracted to a low
of 14.08 bps on June 25 before soaring to today’s heights. Of course, the
significance of these warnings is much easier to understand with hindsight.
Risk management is a valuable input into the investment process, but it is
never an exact science guaranteeing safe outcomes. “Volatility can spike
upwards and then normalise,” Laubsch says. “An early warning sign can go either
way.” Around June, many Australian equity investors seemed to believe that residual
portfolio risk was falling, says Martin Conlon, head of Australian equities at
Schroder Investment Management. But risk increased as listed property trusts
and financial houses thrived on leverage, and commodities prices surged
upwards.
“Everybody looking at the market should have known that risk was increasing,”
Conlon says. Paradoxically, however, volatility measures of the ASX200 consistently
fell. Investors then felt comfortable taking on more risk. Volatility, like
most things in markets, is cyclical. And the worst time to increase exposure to
volatility is when it peaks. Conlon says the resourcesheavy index was no longer
a risk-neutral neutral benchmark in late 2007 (and it rarely is risk-neutral,
since it is dominated by energy, materials and financial companies, which
usually have high intra-sector correlations).
As the credit crunch hit,
leverage began to unwind and commodity prices fell, the index started shedding
capital. Then, just as bearish sentiment took hold, the breadth of the market
narrowed, as the majority of stocks underperformed. Since the market was driven
mainly by one sector, breadth collapsed at an especially bad time. About 20 per
cent of stocks outperformed while 80 per cent underperformed, Conlon says,
providing stockpickers with few options. Risk is often measured by statistical methods,
but can be more accurately recognised in the underlying business of a stock,
Conlon says.
Due to the cyclical nature of commodity prices, the cash flows of
resources companies were volatile. What rose strongly soon fell suddenly. A
good way of analysing the cash flows of cyclical companies, Conlon says, is to
view them in the context of a full cycle and not at their peaks. The degrees of
financial and operating leverage and their impacts on cash flows should also be
monitored. In a battle cry for fundamental analysis, Conlon says investors
should inspect the four “building blocks” of companies – operating and
financial leverage, valuation and stock liquidity – before deciding how much
they should rely on volatility measures.
“Most people look in the rearview mirror
and torture stock price information to make it confess. This is easy to do
because managers have got access – that’s why they use it, not because it’s right.
“Risk is fundamental, not statistical. Investors should demand more fundamental
risk data from funds managers.” Laubsch of RiskMetrics is not so polemical. He
argues that risk management is comprised of equal parts “art, science and
culture”, meaning a combination of fundamental and quantitative analysis, and a
proactive way of dealing with risk.
Both he and Conlon consider the idea that
crises arrive unexpectedly is a “myth”. (The carnage on equity markets is “something
that a hedge fund manager would call a multi-standard deviation event,” Conlon
says. “What a load of rubbish.”) For Laubsch, both quantitative and qualitative
risk analysis can uncover warnings of menacing outlier events. “Everyone talks
about black swans,” Laubsch says. “The subprime bubble was not one – it was a
white swan. People predicted it, but most people don’t want to hear that the
world is going to end when there is easy money to be made.
“Risk is always
underpriced at the latest stage of the party.” Investors who rely on VaR as
their only guide to market volatility are “foolish”, and those who ignore it
are “equally foolish”. Some of the historical VaR simulations used by banks in
the runup to the credit crisis did not identify market volatility because they
were backward-looking. Responsive volatility measures would have been more
useful, Laubsch says.
“If you have a regime shift, which is what happened in
late 2006 to 2007, using historical simulation is quite useless.” Forensic
accounting also uncovers weaknesses in companies. Analysis of New Century
Financial, the first subprime lender to fail, found the business had not
replenished its capital reserves against loan losses, which had been tapped as
subprime defaults accelerated. The company hid this shortfall by combining its
reserves against both real estate and loan losses as one sum. New Century stock
traded north of US$30 in November 2006. In March, the company collapsed.
It
is almost impossible to predict the day
an asset bubble will burst, but identifying
and managing unsustainable imbalances in
markets can be done. A number of
fundamental and quantitative inputs are
required to achieve this, Laubsch says. “If you just purely rely on a model it is like looking only at the GPS while you are driving and not the road. Is it raining? How heavy is the traffic? You shouldn’t just believe the GPS – you need to look outside.”
But measuring risk is easier than managing it at the portfolio level. The job of a risk manager is to dictate “how much is too much”, and when a portfolio manager decides what to invest in, a risk manager helps “size the bets”. It also requires a professional culture that sees risk as a source of
opportunity as well as a threat to
performance. For almost everybody, the
subprime mess has been a disaster.
But
for some hedge funds, it was an
extraordinary opportunity to sell short
the toxic securitised mortgage market. “No matter how great models are, if you don’t have a culture that understands risk, and a proactive risk manager, you will fail. The results become lost.
“You can have great metrics and risk
people within an organisation that doesn’t
respect them, and when the risk managers
say no to a deal, they get fired.”
The problem wit h stayi ng too close to home One risk that superannuation funds are particularly prone to is the
concentration of their exposures to
Australian assets, Laubsch says. These allocations are excessive in comparison to their investments in international equities. “Australia
is a good market, but so closely tied to
the growth of China
and metal prices. China has started to slow and commodities could go through a bear cycle – do you want your retirement savings to depend on the price of commodities?
“If resources perform poorly, this
will send shockwaves through the Australian
economy, precisely when you need safety
in your portfolio. “Retirees will need
their money the most if the economy in Australia
is not good.” Further diversification among asset classes and trading strategies could lower risk, but it would increase manager costs. In crises, when all correlations go to one, these expenses hurt as attempts to diversify can be seen as being made in vain.
Still, “there was a big difference
between whether you held Goldman Sachs
or Lehman Brothers stock,” Laubsch says. “A lot of people have piled into many of the same things at the same time, such as infrastructure and property,” Laubsch says.
“And if you’re in a herd it makes it
more dangerous because if that goes
down, and is driven down further by
investors getting out, that whole market
will hurt at a time when pensioners
need access their money.”
