Rethinking Risk: Changing the Mind-Set from Market to Function

ThinkstockPhotos-185953030Thinking about investments in terms of beating a specific market benchmark has served many very well in the past, but that does not mean such an approach will be appropriate in the future.

‘We are all very wedded to the benchmark and the way that things have been done,’ said Hugh Prendergast, Head of Strategic Product and Marketing, Western Europe and International, at Pioneer Investments. ‘But we believe the future of the active industry is increasingly going to be about delivering function, not relative return.’

This function will be client specific and focused on their objectives, such as achieving a spread over inflation or reaching a set amount for retirement.

Several factors are contributing to this trend. First, in a period of relatively modest economic growth, standard market returns may not be sufficient to meet investors’ needs. ‘The carry we are getting from the beta return is not enough given the risk,’ warned Prendergast.

The potential for a loss of capital is a case in point. In a low return environment, a 20% drawdown would require a 25% gain to recover the capital loss; a 50% loss would demand a 100% return. These are high hurdles given many investors’ timeframes. ‘You simply might not be around on the planet long enough to recover,’ Prendergast said.

Most investors are aware of these dangers. At Pioneer Investments April Conference, over 100 professional asset allocators were asked what they considered to be the most important definition of risk. For 34%, the highest proportion, risk meant drawdown; for 26%, the second highest proportion, it was the probability of not meeting return objectives.

Similarly, when asked what major gaps they faced in their investment strategy, 39% of the conference attendees said it was managing drawdown effectively while for 34% it was generating sufficient returns.

‘Risk is not one dimensional,’ summarised Prendergast. It certainly goes beyond its traditional definition in the investment world: volatility. ‘Volatility is not risk; it is simply movement,’ Prendergast explained. True risk management for investors should factor in volatility, drawdown, and shortfall against targets.

Liquid-alternative strategies can help in all these regards, with Prendergast highlighting how effective they have been in mitigating risk since the financial crisis.

This performance record has not passed unnoticed by investors. The survey of the conference participants revealed that a majority of them, 54%, currently allocated 10% of their portfolios to liquid-alternative funds. Asked how they expected that to change over the next two years, the largest single category, 42%, responded that they expected to move to apportioning 20% of their portfolios to liquid-alternative funds.

Pioneer Investments believes that incorporating liquid-alternative solutions into portfolios will be essential in helping investors meet the functional challenges of the future.

‘We believe that the big advantage of these strategies is that they can bring their strengths to bear when traditional asset allocation may no longer be effective due to unforeseen market turmoil,’ said Prendergast. ‘These solutions are designed to generate market-independent returns in a wide variety of different market phases. By building up add-on positions in liquid alternatives, investors have the potential to also gain access to forward-looking strategies outside the traditional asset classes of bonds and equities.’

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