September marked the tenth anniversary of Lehman Brothers’ collapse, an event that epitomizes the traumatic happenings of 2008. It’s often said that one of the effects of the global financial crisis has been a lingering risk aversion among investors, and, as a result, the pre-eminence of risk management in portfolios.
This phenomenon certainly transpires if one looks at the type of passive equity investments that have garnered momentum in the last decade. The mitigation of risk appears as a common thread that unites many popular systematic strategies, which are otherwise quite distinctive one from the other. Several approaches that don’t state risk management as a primary role do actually play a part in risk control in as much as they address particular sources of market stress.
That facet has only strengthened the appeal of those strategies in the eyes of investors in the post-crisis world.
ESG – sustainability meets high risk-adjusted returns
One example is environmental, social and governance (ESG) strategies. While ESG has seen spectacular demand on the back of institutions adopting responsible investing principles, there is a key side story to sustainable investing: better corporate governance can lead to higher equity returns but also provide protection against certain risks, such as labour-related reputational damage, financial mismanagement, environmental disasters or supply-chain issues.
Companies that monitor ESG risks can better navigate periods of macro volatility. A study published in the Journal of Investing showed that there is a strong negative correlation between ESG ratings and stock volatility, and that this relationship increases when markets go down.1
The study showed that stocks with high ESG scores tend to be in the low volatility group and vice versa, with this correlation appearing in a statistically significant number in almost all time periods. So, while high-ESG stocks have been associated with outperformance in many analyses, what’s important to investors is that those returns are compelling when adjusted for risk.
Geographical targeting as a risk-management tool
Elsewhere, globalization has largely been a positive engine for trade and economic growth. Yet in some cases, the increasingly global scope of the world’s largest companies has challenged the precepts of traditional asset allocation and presented investors with the problem of determining and limiting the effects of geographical risk.
Diverging economic growth patterns within regions, threats to global trade and new geopolitical tensions – from Brexit to emerging markets volatility – are undermining investment portfolios. The STOXX TRU® Indices, which track companies according to their geographic revenue exposure as opposed to their country of domicile, are sought as protection against geographically correlated risk as much as they are used to target higher-growth areas.
Factors and minimum variance
The boom in factor-based strategies in the past decade has also allowed investors to allocate resources to stocks whose features can help make them less vulnerable in volatile markets. That’s true not just of the low volatility factor, but also of quality, high dividend and even value.
Factor investing has also provided a channel for a popular risk-mitigation approach: that of minimum variance, which builds equity indices that are far less volatile than their traditional market-capitalization-weighted equivalents.
Minimum variance approaches overweight stocks that have exhibited the lowest individual levels of historical volatility. But the strategy aims to be more sophisticated than simply choosing low-volatility stocks. It optimizes the risk-return exposure of the entire portfolio across several factors. It avoids unforeseen risks and takes intra-stocks correlation into account to limit biases towards specific sectors. The result is particularly beneficial at times of increased volatility.
Beyond these, there are other strategies that primarily follow risk-management objectives: from risk-control approaches, to systematic dynamic allocation, to currency hedge.
A rich toolbox for risk management
Risk management has in recent years grown alongside passive and systematic investment strategies. The former has been an important driver for the latter, even if it is not immediately obvious. It has been somewhat of a ‘fil rouge’ for many investment approaches, only some of which I’ve described above.
The toolbox for an effective, long-term weather-proof portfolio was never as rich as it is nowadays. This is the result of the sophistication of asset management in general and of passive investments in particular. And one of the positive outcomes of the global financial crisis.
1De, Indrani and Clayman, Michelle, ‘The Benefits of Socially Responsible Investing: An Active Manager’s Perspective,’ Jul. 11, 2014, Journal of Investing.