VaR is based on historical data over a relatively short time horizon (roughly five years). The trouble is volatility regimes also tend to last between three to five years. Therefore, VaR will appear lowest at the end of a prolonged period of low volatility, encouraging investors to take more risk just before volatility spikes and prices correct. Likewise, VaR will appear highest after a period of prolonged high volatility, encouraging investors to cut risk just before markets enter a period of calm.
But VaR was never intended to be used as many investors are doing so today. It started as an attempt to measure risk, but as David Lloyd, head of institutional portfolio management at M&G Investments, says: “It migrated into a tool used to justify taking risk and sometimes forcing people to take risk. That is pretty toxic.”
He continues: “Investors tend to look at their target returns, make realistic estimations of how much a skilled manager can produce and then calculate how much risk they need to take in order to do that. That is why you hear people saying managers are not taking enough risk. That is all well and good until there is a big spike in volatility, which changes the risk profile quickly and too much risk is being taken. People then sell assets or unwind positions because of VaR warnings.”
In an ideal world, investors should be doing the exact opposite of what VaR would suggest – reducing risk just before volatility hits and booking profits gained during the preceding period of low volatility, and adding to risk as volatility falls away to take advantage of opportunistic pricing.
Predicting exactly when those pivotal moments in the volatility landscape will occur is, of course, extremely difficult, but the problem many institutional investors face is the length of time it can take them to adjust a portfolio into a new volatility regime.
Ed Peters, co-director of global macro at First Quadrant, says: “A lot of the metrics for risk analysis are backwards-looking. They therefore give you low volatility values just as you are heading into a period of high volatility. Investors don’t prepare for this and don’t realise a period of high volatility is upon them until after it has started and by the time they have moved their portfolio, it is almost over.”
The combination of VaR, given the recent prolonged period of low volatility, and the low yield environment has placed massive pressure on investors to seek yield by taking on risk, which has been blamed for creating bubbles in parts of the market, pushing valuations up and yields down.
The dramatic change in long-dated bond yields has had a huge impact on investors. As Lloyd says: “30-year gilts traded at around 4% to 5% for the best part of 15 years. As they dropped through four and continued on an unbroken march downwards to 2.25% today, that has been a game changer.”
John Dewey, managing director at Blackrock warns: “As investors hunt for yield, even some of the more attractive opportunities are getting eroded. Investors have to be increasingly careful about price, even if the asset looks attractive. During the credit crisis, UK investment grade credit offered attractive yields of up to 10%, but this has reduced almost to 3% recently.”
Many institutional investors have therefore turned to assets such as long lease property or infrastructure to deliver secure income over the long term. These have not been immune, however, with prime property yields falling below 4%, forcing greater diversification of portfolios to different sectors and secondary locations. Similarly, some senior infrastructure debt may offer a thin margin of less than 1% above a similar corporate bond.
Investors’ herding behaviour, and the detrimental impact it has had on their own financial health, is clear to see. Yet, it is important to realise that many of the hurdles they face in buying low and selling high are not of their own making. Regulation, accepted investment practice and the unending drive to de-risk are all to blame while transparency and the sheer volume of information now available makes it all the more difficult to resist the urge to react to underperformance.
As JLT’s Finch says: “The challenge is getting through all that mud.”
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