Systematic Risk Management and Capital Preservation
One of the reasons almost all financial advice takes diversification for granted is that it is the most straightforward defense against individual asset volatility – the low hanging fruit of basic risk management, if you will.
But the risk of large losses is not fully mitigated by diversification alone. Diversification is just a starting point. To mitigate against large losses (like those experienced by many investors in 2022, for example), wealth managers and investors need to select investment strategies and funds that incorporate capital preservation measures.
Below, we break down how investors can understand systematic risks and provide some examples of investment strategies that can mitigate exposure to large losses in their investment portfolio.
Understanding and Managing Systematic Risk
Systematic risks are risks associated with crisis across a large number of sectors of the economy or of the financial system itself. They are the opposite of idiosyncratic risks, which are specific to individual businesses, industries or asset classes. Systematic risks embody economy-wide crises that have negative consequences for all investors.
Probably the most notable recent examples of systematic risk are the Great Recession (GR) in 2008–2009 and the COVID pandemic crash of 2020. In the GR, the bursting of a bubble in one specific sector that led to a global economic downturn may seem odd. But turbulence in the housing market — starting with the subprime mortgage market — created risks and economic effects far outside one industry.
What Are Some Common Types of Systematic Risk?
Systematic risks vary in their causes but are similar in their impact; they produce significant exposure to losses because they affect entire economies or the financial system itself.
Common systematic risks include:
Market Risk – Any wide-scale changes to the market will impact nearly all investors. Market risk is interchangeable with systematic risk.
Currency Risk – Normal oscillations in currency exchange rates are to be expected, but irregular fluctuations can have large, economy-wide, impacts on import and export prices and therefore virtually all goods and services.
Interest Risk – Interest rates cause two inversely related kinds of systematic risk. The first, reinvestment risk, is when reinvesting dividends could earn less in the future. And the second, price risks, arise when higher interest rates drive asset prices down.
Inflation Risk – Also known as purchasing power risk, this refers both to consumers’ ability to support the economy and the real impact of portfolios’ investment income.
Political and Regulatory Risk – Governmental actions such as declarations of war, new regulatory measures, or bailouts can cause major ripple effects across all asset types.
Managing systematic risks means managing a portfolio in a way that minimizes exposure to the large potential losses these risks can impose.
Key Components of Systematic Risk Management Investing
The first priority in purposefully managing exposure to large losses is identifying, monitoring, and measuring the various systematic risks mentioned above. On that front, the most commonly used measure is beta (β). Beta measures an asset’s or a portfolio’s sensitivity to overall stock market fluctuations in the most basic sense, but can also be applied to the fluctuations of any market or economic measure like those mentioned above (currencies, interest rates, inflation, etc.).
Careful security selection and portfolio construction coupled with continuous risk monitoring and active rebalancing can be used to control the market beta, inflation beta, interest rate beta, currency beta, etc., of an investor’s portfolio and thereby reduce exposure to systematic risk and large losses.
With respect to managing systematic risk, diversification is less about asset class selection and more about exposing a portfolio to a variety of different kinds of risks that will tend to pay off at different times. Assembling a portfolio of uncorrelated risks, and then adjusting the portfolio over time as risks evolve, often provides the highest protection against large losses brought about by systematic crises.
Such a systematically diversified portfolio might include a mix of high-β and low-β assets, along with insulation from particular risks discussed above. For example, local businesses that do not engage in international trade may be less encumbered by changing exchange rates. They (and associated businesses) would carry less currency risk. With a deep understanding of systematic risks, exposures can be created to mitigate the impact of these risks on an investor’s portfolio.
Benefits of Systematic Risk Management: Case Study and Examples
Investors want their capital protected. The likelihood of a major stock market crash over any 10-year period is about 33%. Over 30 years, including reinvestment of dividends, the probability of real-dollar valued stock portfolio loss is over 12%. Disastrous equity performance — zero real return over 30 years — cannot be ruled out.
A loss over a long investment period is particularly damaging to an investor because it consumes much of their viable saving period without generating wealth. Markin Asset Management’s strategies empower advisors and investors to sidestep the worst outcomes of these scenarios by systematically seeking to avoid large losses in times of stress by actively managing risk exposures.
Over the up and down market of 2021 and 2022 all our strategies outperformed their benchmarks and throughout 2022 we’ve received overwhelmingly positive feedback from advisors about the capital protection value our strategies delivered.
Incorporating Systematic Risk Management in Investment Processes
It is a fund manager’s job to incorporate systematic risk management into the investment process so that his/her fund’s are protected from over exposure to the evolving risk environment. Advisors should select managers with a proven track record of mitigating exposure to large losses in times of stress.
As distant as it may seem when markets are trending upward, all advisors and investors should recognize that the risks of the next crisis are lurking in the background and be mindful of the potential exposure their portfolios have to those threats. From the advisor and investor’s perspective, manager due diligence and selection can go a long way toward establishing performance expectations and improving downside loss outcomes.
Systematic Risk Management Techniques
The most direct way to deal with systematic risks in a fund or investment strategy is to account for and incorporate them intentionally. Applying the components above means some combination of:
Asset Allocation – As previously noted, diversifying away systematic risks look different from diversifying away idiosyncratic risks. It requires taking a variety of systematic risks into consideration across asset classes and finding ways to achieve uncorrelated security performance when these risks manifest.
Active Risk Management and/or Hedging – A more strict application of dynamic risk allocation continually balances higher-beta investments with lower-beta ones, aiming to maintain the desired/target beta (risk exposure) for each risk factor.
Risk Monitoring and Review – Fund managers can also apply further analytical rigor to their portfolios, beyond CAPM-style betas, which may tend to result in a rather static view of what is in fact an ever-evolving risk environment for a portfolio. For example, real-time proprietary research into assets and their various risk exposures may produce a portfolio with improved capital preservation characteristics.
Capital Preservation Strategies
Funds and strategies with capital preservation characteristics prioritize downside loss mitigation and generally this implies having a well-oiled, sophisticated, quantitative approach to risk management that can balance capturing opportunities with navigating against large losses over market cycles.
Some strategies in this vein include:
Dynamic Risk Allocation – Adjusting portfolio exposures as needed to keep a fund within it target risk envelope at all times.
Defensive Investment Approaches – Focusing on portfolio construction where the types of assets (or portfolio composition) are selected for their ability to minimize loss and maximize stability amidst market-wide crises. Low volatility funds would be an example of defensive investing.
Optimize Your Risk Management and Capital Preservation
Systematic risks have a way of hiding in plain sight and then accelerating into full-blown crises. In some circumstances, a systematic fund or strategy can thrive amidst market-wide strife by profiting from increased price movements.
Ultimately, the best approach to mitigating against downside losses comes down to selecting a fund manager or managers who systematically incorporate capital preservation methods into their day-to-day investment management processes. At Markin Asset Management, our philosophy is based on diversification and dynamic risk allocation. It seeks to ensure that the riskiness of each portfolio diligently and continuously remains consistent with advisor and investor expectations.
To learn more about how capital preservation can benefit your practice, get in touch today.