Trading Risks in International Investments

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Relative value and market neutral programs, also commonly known as long short programs. Are among the most intellectually appealing and widely misunderstood investment strategies. They seek to attain low volatility profits in rising or declining markets. Essentially, the strategy entails the construction of a portfolio of long and short positions. The portfolio profits if the manager’s relative valuation leads to a rise in the value of the long positions and or a decline in the value of the short positions. Relative value strategies differ from “directional” investment, in which the gain or loss comes from the rise or fall in price of a single asset rather than the relative movement of two or more assets.

Closely related to relative value programs are market neutral programs. Market neutral  portfolios are constructed so that the portfolio’s assets are relatively insensitive to the up and down movements of major markets, whether stocks, bonds, currencies, or commodities. In contrast to relative value, where two or more offsetting assets are meant to neutralize or reduce risk, market neutral strategies reduce risk to a wider market movement.

In theory, market neutral investments should be less risky than relative value investments, since they afford protection against large scale market movements. In practice, however, market neutral strategies tend to be more highly leveraged, reducing the difference between the strategies.

Given the recent upheaval at long term capital management, it might appear inappropriate to place relative value and market neutral strategies in a section on risk management methods. In their genesis and in practice, however, these strategies are meant to reduce the risk of investments. Relative value models are used to statistically measure the historical correlation between the prices of related assets, be they bonds, stocks, or currencies. Often, the analysis shows a  divergence from historical price patterns, presenting an opportunity to profit from the reversion of prices to historical norms. At other times, the calculation is based on the assumption that prices and relationships will remain stable, allowing a profit from the differential in yield between assets. In recent years, examples of the former include buying Italian government bonds and selling German government bonds, looking to profit from the convergence of interest rates as the European markets converged. An example of the letter would include the purchase of mortgage securities hedged by U.S. government bonds, the goal being to lock in the interest rate differential.

The attractiveness of market neutral and relative value strategies is their “built in” hedge. If properly structured under the right market conditions. These spreads are able to produce relatively low volatility returns in a wide range of market conditions. There are many types of market neutral and relative value strategies.

Problem with Market Neutral Strategies

       It is obvious that market neutral and relative value strategies also have some severe problems. Both in theory and in practice. Many of these problems have to do with the trading and execution of relative value positions, especially during times of market distress. One of the most baffling aspects of the Asian crisis of  1997-1998 was the speedy turnaround in the investor’s perception of risk and, consequently, of risk premium. This change led to a dramatic increase in the spread between higher and lower risk assets and to divergences between assets that had previously moved in the same directions.

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Risk Targets and thresholds

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A third application of VaR to asset management involves measuring and monitoring market risk using a formal system of predefined risk targets of thresholds. In essence, risk thresholds take ad hoc risk monitoring one step further and systematize the process by which VaR levels are evaluated and discussed for portfolios or managers or in some cases, for the whole investment fund.

A system of risk thresholds is tantamount to setting up a tripwire around an investment “field,” where the field is characterized by a fund’s investment policy and risk tolerance. This tripwire is defined in terms of the maximum tolerable VaR allocated to a manager or portfolio and then is monitored by regularly, e,g., weekly, comparing actual VaRs to these predefined targets. Investment managers are permitted to leave the field when they wish, but the tripwire signals senior managers that they have done so. When a tripwire is hit, i.e., a VaR threshold is breached, an “exception report” is generated and discussions and explanations are required.

Risk targets can be specified in terms of absolute or relative VaR. a private bank might conclude, for example, that a particular client’s capital should never be placed at risk above a certain amount, regardless of the risks taken by other clients or managers. In that case, the traders on that client’s account could be subject to an absolute VaR threshold. A mutual fund, by contrast, might prefer to specify its risks targets relative to the VaR of its benchmark portfolio or peer group.

The hallmark of well functioning risk target system is not that targets are never breached or that all exceptions are rectified through liquidating or hedging current holdings. Rather, the primary benefit of a risk target system is the formalization of a process by which exceptions discussed, addressed, and analyzed. Risk thresholds thus are a useful means by which asset managers can systematically monitor and control their market risks without attenuating the autonomy of their portfolio managers. Because the primary purpose of risk limits is to systematize discussions about actual market risk exposures relative to defined risk tolerances, huge investments in VaR calculation systems, moreover, typically are not required. Even an imprecise measure of VaR will usually accomplish the desired result of formalizing the risk monitoring process.

Risk limits and Risks Budgets

       A more extreme version of risk targets and risk thresholds is a system of rigid risk limits. This application of VaR is also known as a risk budget. In a risk budget, the fund’s total VaR is calculated and then allocated to asset classes and specific portfolios in terms of absolute and benchmark relative VaR, as well a shortfall at risk (SaR). Managers are the required to remain within their allocated risk budget along these risk dimensions. So whereas a risk target resembles a tripwire around a field that a manager must account, ex post, for crossing, a true risk budget instead acts as an electric fence around the field that managers simply cannot cross, ex ante. a total risk budget defined across all portfolios can create numerous problems for an asset manager. First, risk budgeting relies at some level on the absolute VaR of a fund and its portfolios. To the extent that the measurement methodology is flawed, the risk budget will be wrong.

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Inflation and Public Debt

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          Significant monetization of budget deficits fuels price inflation, which can undermine popular support for governments. As a result, policy makers usually respond with measures to contain it. If they do not, and price increases accelerate, serious economic damage and erosion of public trust in political institutions can result. Such conditions are fertile ground for a sovereign default. For these reasons, Standard & Poor’s regards the rate of inflation as the single most important leading indicator of sovereign local currency credit trends. Inflation benchmarks and their relationship to different local currency rating categories.

          In evaluating price pressures in each country, Standard & poor’s considers their behavior in past economic cycles. The analysis is based in part on the level and maturity structure of the public debt burden total borrowings of central , regional, and local governments in relation to GDP together with the likely extent of future borrowing. Off balance sheet items, public sector pensions, and contingent liability items, such as bank and other enterprises, are scrutinized for their possible contribution to inflation. Related indicators include rates of money and credit expansion. Taking all these factors into account, the rating service makes a conservative assessment of average inflation over the next cycle, as measured by the consumer price index.

          In addition, Standard & poor’s looks at institutional factors affecting inflation. For instance, an autonomous central bank with a public mandate to ensure price stability can be a strong check on fiscal imbalances, less so a central bank tied closely to the government. Among industrial countries, AAA rated Germany and the U.S provide excellent examples of central banks where strong traditions of independence have evolved over the years. Similar examples among emerging market issuers include the central bank of Chile and Israel. On the other hand, Mexico’s credit standing (BB foreign currency and BBB local currency) does not particularly benefit from the Banco de Mexico’s formal autonomy, given the federal government’s continued influence over the institution.

          The depth and breadth of a country’s capital markets also can act as an important discipline. The sovereign has fewer incentives to default on local currency obligations when they are held by a board cross section of investors rather than concentrated in the hands of local banks. For this reason, the establishment of mandatory, privately funded pension funds in a number of countries Chile and Argentina, among others helps bolster their credit standing by creating an influential new class of bondholders. The experience of many OECD countries suggests that even when public debt is high, creditworthiness can be sustained over long periods when policy makers are responsive to constituencies with vested interests in safeguarding the value of money.

Foreign Currency Debt Rating Factors

          Of course, the same economic and political factors affecting a sovereign’s local currency credit standing also impact its ability and willingness to honor foreign currency debt, often to a greater degree because of the binding constraints the balance of payment can impose. As a result, Standard & Poor’s analysis of foreign currency debt focuses on how government economic policies influence trends in public and private external debt levels over time.  

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Why isn’t Everyone Doing Multiple Asset Class investing?

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If multiple asset class investing is so wonderful, why isn’t everyone doing it? There are three primary reasons. First, investors lack an awareness of the power of  diversification. The typical investor understand that diversification may reduce volatility but suspect that it simultaneously impairs returns. Not diminish them. Investors need to be educated about this dual benefit.

          Second, the question of the market timing arises. Investors naturally want to believe that there must be some way to predict which asset class will come in first place. And some money managers suggest that they in fact can make such market timing predictions accurately. Let’s assume that we have a market timer with whom we consult annually for his prediction of the following years best performing asset class among the S&P 500, EAFE, NAREIT, and GSCI. Had he successfully predicted the winning asset class over the past 15 years, from 1983 through 1997, an investor following his recommendations would have earned a compound rate of return of 32.33 percent. If such market timing skill exists, there should be evidence of money managers earning these rates of return. A check of morning star’s database, reveals that there is a universe of nearly 600 mutual funds with at least 15 years of performance history. Included is the full variety of professionally managed domestic and international funds, equity and fixed income funds, as well as various specialty funds. How many of these funds had compound rates of return in excess of 32.33 percent? None! Not one got remotely close.

          Maybe we are asking too much proficiency from our market timer. Let’s assume that his prediction for the winning asset class each year never finished first but instead came in second place among the four asset classes. This does not seem like a particularly impressive achievement. Yet it would have generated a 15 year compound annual return of 19.59 percent. Out of nearly 600 funds, only three had better investment performance. This is only one half of one percent of all professionally managed mutual funds. And none of the three funds relied on market timing to deliver their impressive returns.

          Perhaps that is still asking too much of the market timer. What if we ask him to simply recognize the long periods of dominance of one asset class over another? For example, our market timer might instruct us to invest our funds in EAFE during the portion of the 15 year period that fell in the 1980s and then switch to the S&P 500 for the 1990s. this strategy would have generated a compound return of 22.81 percent. Again, not one mutual fund manager among 638 funds achieved that rate of return. Apparently, predicting the performance of asset classes is hard to do successfully.

          The third reason involves investor psychology. Investors use their domestic market as a frame of reference for evaluating their investment results. For example, a united stated based investor will compare her equity returns to a market index like S&P 500. This frame of reference is not a problem in years when the domestic market underperforms other asset classes, since diversification into better performing markets rewards a multiple asset class investor. When the domestic market comes out on top, however, the investor perceives that diversification has impaired her returns. 

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The Dynamic Reality of Global Equity Risk

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The last half of the 1990s has witnessed numerous examples of risk impacting the portfolios of global equity market investors extreme market volatility, political instability, changes in economic systems, and operational dislocations have all added to the risks that international market have presented to investors during these turbulent last few years of the century. The Mexican peso crisis of 1994-1995, the sharp drop in the south African rand in 1996, the Asian currency and economic crisis of 1997, defacto default on sovereign debt by Russia, and the imposition of capital controls by Malaysia in 1998 are all salient examples of some of the macro level exogenous shocks that hit international equity investors. Yet micro level changes can have an equality dramatic impact on portfolios, for examples, the reduction of restriction on foreign investors in Korea, Indonesia, the Philippines, and Singapore in 1997, or the treatment of major privatizations and cross border merger by benchmark index providers in the 1997-1999 period.

Despite these macro and micro level risks, cross border equity investing continues to grow, largely due to the benefits of diversification and potential return enhancement. The simple fact that risks and returns in world markets are not perfectly correlated means that when appropriately diversified, market risk can actually benefit global equity investors. But this risk must be understood, measured, and effectively managed. And other types of risks, primarily operational in nature, are almost never a benefit to investors, and must be either avoided or mitigated.

This chapter provides an overview of the investment risk that a global equity manager must address. It provides numerous examples to illustrate key points, but it makes no attempt to comprehensively detail the myriad country and security specific risks present in the world equity markets. The chapter is designed to be a general overview. From a practitioner’s perspective, and is structured using current, real world examples that large institutional fund managers (such as Barclays Global Investors) face when operating in this asset class. Subsequent chapters of this book address in more detail the various players in the market place, the techniques and instruments of risks management, and regional and country specific risk factors.

The definition of risk in a standard dictionary is “the potential likelihood of a loss.” This would seem to suggest that it is something to be avoided at all costs. In the world of equity investing, however, not all risks can or should be sidestepped. Risks that arise as a result of a poorly managed investment process should not be tolerated. Since they increase the uncertainty of the final outcome without a commensurate improvement in expected return. Also eschewed should be all unsystematic or diversifiable risks, again because they bear no compensation. Systematic risks, however, can be accepted selectively based on their expected return and on their marginal effect on the investor’s total portfolio risk.

Furthermore, certain international equity risks, such as currency risk, may in fact deliver a positive element of diversification to a predominantly domestic portfolio. This potential benefit means that, if a developed international equity allocation is not unduly large, it is usually not optimal for the investor to hedge currency exposure.

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