Tread carefully among systemic risks

Funds managers, pension trustee boards and fund members should adjust to a low-returns environment and think carefully about investment risk in such uncertain times, warned Tim Gardener, global head of consultant relations at AXA Investment Managers (AXA IM) and a veteran of the UK asset consulting industry.

Tim Gardener, who was global CIO of Mercer before joining AXA IM, said communicating this reality to all fund stakeholders was vital to secure long-term investment returns.

“God didn’t come down from the mountain and say you can always have 10 per cent returns on your investments, and I do think that this is a period where we will get lower returns and people just have to get used to it,” he said.

“The danger is [that] if they don’t get used to it, investment managers will go in pursuit of riskier and riskier investments to try and maintain returns.”

Such strategies would stray from the core purpose of pensions: to deliver long-term, risk-adjusted returns.

Gardener said the investment industry should look at ways of truly focusing on long-term objectives and not be too distracted by short-term performance rankings or market ‘noise’.

“There are a number of things you can do, and none of them are a silver bullet, but the prize is so worthwhile that they are worth doing.”

Such as: presenting information to members and boards that emphasised long-term aims and objectives; eliminating market-capitalisation indexes as benchmarks; and implementing governance processes – rather than just talking about them.

Contrary to popular opinion, Gardener argued that the global financial crisis was not caused by dishonest bankers and incompetent regulators but by a misreading of investment risk.

“It is not very newsworthy, but what caused the great financial crisis is that everyone had the same mean-variance risk models and statistical risk models,” he said.

“While they may have had different forms, these risk models were all giving the same message: that risks were manageable and the problem is that statistical models have their limitations.”

He said investment managers should look for the “build-up of pressure” in the financial system – such as the untrammeled securitisation of US mortgage debt before the financial crisis – as an indicator of the next “financial earthquake”.

Rejecting the notion that the financial crisis was a so-called “black swan” event, Gardener said market tumults were likely to happen again because there was little evidence the “buy more, work less” approach of Western societies had changed.

He said current inflation worries were an indication that pressure was again building in the global economy.

“If you start looking at events in this way – if you think of them as earthquakes – then you don’t know when or where, and you know it isn’t going to be exactly like the last one,” he said.

“But the one thing you do know is that it is going to happen.”

He advised investment managers to stress-test their strategies in a range of simulated worst-case scenarios to make sure they could withstand downturns.

An advocate of integrating thematic and behavioural investing theories into an overall investment strategies, Gardner also said long-term investors should identify future trends that could impact investment returns.

Some themes he identified for the next 10 years included:

• the shift in economic power from West to East;
• extreme wealth inequalities in many emerging nations, particularly the oil-rich nations;
• energy, food and water shortages; and
• demographic trends, which include an aging population in the West.

Speaking alongside Gardener, AXA IM’s senior adviser for responsible investment, Dr Raj Thamotheram, talked about how sustainability concerns should play a major role in investment decisions as they had the capacity to substantially affect the value of investments.

He pointed to the causes of the global financial crisis and compared them with a case study of the recent BP oil spill in the Gulf of Mexico.

Thamotheram said the two events shared underlying drivers. These included:

• the degrading of regulatory authority through extensive lobbying;
• the inability to learn from past mistakes;
• a narrow conception of risk; and
• a focus on short-term returns that were unsustainable.

Rather than treating sustainability as a peripheral concern, Thamotheram argued the diminishing safety culture at BP resulted in a number of incidents that were unheeded until the final spill occurred and resulted in an environment catastrophe and wiped $40 billion in shareholder value from the company.

He provided a number of solutions, including more transparent reporting and genuine integration of sustainability principles into investment strategies.