Brittain said the equity risk factor “sneaks” into endowment portfolios through securitised property exposures and private equity, which he described as “public equity with an illiquidity premium”. This contributed to the correlation of between 0.6 and 0.7 of the endowment portfolio with the MSCI World index since 1993. It is the dominant factor during market crises, he said. Correlations among asset classes rose “in absolute value” when equity markets were extremely volatile, meaning that diversification provided small defence in market crises. He said market shocks, such as those described by the “fat tails” that lie outside a normal distribution of returns, occur more often than most investors and risk management models predict. Since 1982, when Mexico defaulted on its debt, global markets had experienced nine crises, such as the 1987 Black Monday crash, the Asian financial crisis and the recent global recession.

He said traditional risk management and pricing tools often underestimated the frequency and severity of these “left tail” events. Models largely based on economic and market rationality, linearity and normal bell curves were doomed to fail. So what should institutions do? Given the dominance of the equity risk factor, he said they should focus less on asset-class diversification and spend money on a hedging program to mitigate whippings by tail events. A hedging program over a traditional portfolio designed to limit losses to 15 per cent in a crisis could be run on about 100 basis points each year. For the next three-to-five years – “as we recover, or not, from the current crisis” – longer-dated, out-of-the-money options would be useful for hedging portfolios.

Speaking alongside Brittain, Sean Henaghan, investment director of the AMP Capital Investors $96.9 billion Future Directions Funds, said 100 basis points was too expensive, particularly in choppy markets, for a risk-hedging strategy. He said fund must concentrate on the underlying risk factors in asset classes as they sought diversification. “You want to diversify from the equity risk premium, but in doing that you have to make sure that you’re not moving into assets that are overpriced or correlated with the same premium.” Also on the panel, Fiona Trafford-Walker, managing director of Frontier Investment Consulting, said funds should remember their investors when they thought about risk. “The only risk worth considering is not getting the CPI plus 3 per cent or 4 per cent for members in retirement,” she said. Beware correlations when looking at Asia…

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