No rewards as systemic risk and turbulence ratings soar

The market is reflecting a high state of systemic risk and turbulence, and investors should adjust their allocation to growth assets accordingly, says Lucas Turton, chief investment strategist of Windham Capital Management.

Windham, which is a Boston-based risk management firm and a State Street Associates founding partner, looks at the world according to a proprietary Investment Risk Cycle, which describes how financial turbulence and systemic risk interact with each other and how that interaction impacts asset values.

According to Turton, the manager identifies six states of the world, each with “high” or “low” ratings for systemic risk and turbulence. In building portfolios, investors need to be cognisant that assets behave differently to each other within those different states.

“When there is low systemic risk and low turbulence, then you make a lot of money when you take risk. In state six, the other end of the spectrum, growth investors lose money, and there is high systemic risk and high turbulence,” he says.

Windham’s view is that the market is currently around “five”, which means investors should be cautious with risk.

“This means investors will not be compensated for taking excessive risk,” he says.

To put this in context, during the global financial crisis the risk cycle was at “six”, but with levels of systemic risk and turbulence that hadn’t been seen before.

“On a scale of one to six, the GFC was more like an eight,” Turton says. “Looking back at the data, because the financial sector was so important in driving risk, the response in the market was more severe than in the technology sector crisis. Moving forward we see the energy sector as a big factor in pushing markets around. There are too few observations to draw great conclusions, but energy, oil shocks and commodity prices are something to watch.”

Turton says the manager believes there are fewer opportunities in risky assets, so its strategies are below benchmark risk. The Windham Portfolio, which is the largest portfolio, has 50 per cent growth assets as its benchmark.

“We don’t want to frighten people, but they need to understand [that] being more aggressive in certain environments is more appropriate than others,” he says.

Windham, which uses ETFs to implement its strategies, believes that understanding and focusing on how risk evolves, not just when it occurs, means you can take advantage of the relationship between risk and return in different market cycles.

But Turton says Windham does not aim to predict the market outcome, or “win the one-week trade”.

On average, it trades five times a year.

“But the average is not to be expected,” Turton says. “In August we reduced risk twice. But previously we were in state one from August 2009 to November 2010 when we rebalanced and then changed our view.”

“You might get the relative value of Coke versus Pepsi right, but when systemic risk is high then they are both going down.”