Some of the most dangerous risks that investors face today are reported in news headlines. Underpinning stories about Greece’s potential exit from the shared euro currency and anaemic United States economic growth is a key theme that Patrick Farrell and his investment team use to oversee $9.8 billion in multi-manager funds at Advance Investment Solutions.

“2012 and 2013 are going to be years when risk management is the focus – as opposed to chasing and maximising returns,” says Farrell, head of Westpac- owned Advance, which runs the multi-manager products of Advance Asset Management, Asgard Capital Management and BT Financial Group.

“2009 was about a rebound and regaining some of the doom and gloom that got priced into the market,” says Patrick Farrell.

Bullish attitudes towards resource stocks and a theory that the economic fortunes of India, China and Brazil had de-coupled from the West fuelled the last charge of the bull market until mid-2007. Then speculative bets on US subprime mortgages crashed and the 2008 financial crisis showed how interconnected global markets had become. Investors sought the safety guarantee of US Treasury bonds amid bad news.

But 2009 showed how willing governments and central banks were to pump cash into economies to prevent the banking system from collapsing.

“2009 was about a rebound and regaining some of the doom and gloom that got priced into the market,” Farrell says in a broad Australian accent from the boardroom of Advance’s George Street offices near Circular Quay. “That was also the point where you needed to realise that authorities will step in and the sun will still come up tomorrow.”

Bailouts preventing sovereign-debt default in Ireland, Portugal and Greece sparked a “risk-on” stock-market rally towards the close of 2011. But further political fracturing in Europe, culminating in the election of socialist Francois Hollande as president of France and a Greek national election in May renewed investor uncertainty at the dependence of the US and European economies on policymakers.

When the return is not justified by the risk you’re taking, you need to do something about it.

“We feel that event though the market has had the ability to rally over the year to date, the good performance that we’ve seen is more of a reflection of the liquidity that has been pumped into the system,” Farrell says. Europe’s debt crisis and the uncertain outcomes of fiscal stimulus in the US prompted Advance to redeem 3.5 per cent of invested capital in Australian and international stocks to increase its allocations to so-called growth- alternative investment strategies, such as global macro hedge funds. The multi-manager currently invests 8.5 per cent of its diversified funds in the strategies to better capitalise on shifts in market sentiment. It also invests 4 per cent of its assets in commodities and 2 per cent in credit strategies classified as defensive alternatives. This should enable Advance to capitalise on sentiment shocks from Europe and the US as the world’s largest economy endures political gridlock in an election year, according to Farrell.

“There are still too many one-off factors that can come out of left field and cause a risk-off trade,” he says. “You have a political landscape that is dominating the market and political events are very hard to predict.”

Continue taking risks

Capital preservation is paramount. But it doesn’t justify abandoning the search for returns.

“It’s not about avoiding risk. You’ll never get the timing right. It’s about continuing to take risk, but when the return is not justified by the risk you’re taking, you need to do something about it,” Farrell says. “You’ve got to not fall in love with markets when they’re rallying, but not to get too bearish at the bottom.

“If I was to put options protection in place all of the time, I might as well put my money in cash. So you only need to contemplate these strategies when the market is well and truly over the top and is not accounting for risks.”

Advance manages short-term risks by purchasing options that complement the securities held by underlying managers. The short-term, or tactical, limits and long-term strategic asset allocation are approved by the board and allow the team to underweight asset classes by up to 10 per cent if market risks rise.

“We’ve explained to the board that if there is a situation when we really think there is a greater need for capital protection – if markets rallied aggressively and we didn’t think that was justified – that we would go to them and say we’d like to put in place downside strategies.”

Advance uses macroeconomic and financial-market research to inform its selection of fund managers. It seeks liquid, decisive investment strategies and demands transparency on managers’ positions and risk- management policies. Dan Simpson, senior investment consultant at Towers Watson, is responsible for co-ordinating investment advice, manager research and running day-to-day interactions.

The global endgame

Felix Stephens, Advance’s head of capital markets research, recently returned from an annual round of meetings with senior central bankers, economic researchers, political advisers, academics and fund managers in overseas markets. He learned that markets might become even more reliant on policymakers. “We get the sense that there is still more stimulus that can be pumped into the economy, and they can do it in more direct ways,” Farrell says, relaying Stephens’ report on the US Federal Reserve’s capabilities. “If you have a shock to growth and get high unemployment, they will act.”

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