The research and management of systemic risk is critical for the long-term performance of investment managers. Portfolio value changes during crises are often extreme and adverse to many sensible trading strategies. It is hard to predict crises. Yet it is possible to judge systemic vulnerability once crisis-like dynamics get underway. This may provide opportunities to liquidity early or to “sit out” market turmoil. This requires preparation of crisis strategies, a realistic calibration of tail risk and an active exchange of market risk information across investment managers.

The importance of managing systemic risk

Economic and social benefits

  • Systemic risk materializes rarely and is easy to neglect. Yet researching and managing systemic risk is essential for the long-term value generation of investment managers. This is true for from the perspective of both individual performance and social benefits. How a manager deals with systemic risk often makes or breaks long-term performance. The majority of investment strategies are some combination of directional market exposure and relative value, managed by Value-at-Risk estimates. Systemic crises typically derail both of them. This is because in contrast to normal market drawdowns, systemic pressures trigger mass forced position liquidation, due to funding, accounting or legal constraints, often with no freedom of choice for portfolio managers. In systemic events the principles of sensible positioning or flows may not only be suspended but reversewith the best-value position (by conventional standards) posting the greatest loss at great speed and size. Essentially the priority changes from searching for returns to preserving capital. Hence, for responsible portfolio managers systemic risk is an extreme form of setback risk (view summary of setback risk here).
  • If asset managers prepare for systemic crises, the impact of shocks on the financial system and the economy will be less severe.  It is often the very lack of protocols for difficult situations that leads to poor decisions and propagates crises (view post here). Also, the record of the industry does not look favorable. There is ample evidence of regular boom and bust investment cycles, herding, trend chasing (view post here), inefficient expectation formation, and speculative bubbles. Cognitive behavior can often be inconsistent with efficient markets (view post here). There is also evidence of a single global financial cycle driving capital flows across a wide range of markets, the catalyst of which appears to be model-based risk management of banks and other financial institutions (view post here).
  • Managers’ consideration of specific systemic crisis risk can also reduce the probability such crises.Most crises follow from excesses and economic imbalances. An excess of leverage reduces the capacity to absorb drawdowns. The recognition of risk typically increases the price for exposure to the risk and hence discourages its build-up. A relevant example for the future is the unsustainable use of the environment and climate change (view post here). This however requires long term thinking.

“Systemic risk has two effects: One, it reduces the gains from diversification and two, it penalizes investors for holding levered positions.”

Das and Uppal, 2004

Approaches to managing systemic risk

Preparing crisis strategies

Researching systemic risk helps dealing with recurrent crises. It increases chances of early portfolio adjustment, mitigates paralysis and panic and reduces liquidation costs in tight liquidity.

  • Adjusting portfolios early: In the absence of information advantage, a case can be made for adjusting exposure to popular trading styles (or “factors”) in accordance to recent volatility, since it is a good predictor of future volatility but not a reliable predictor of future returns (view post here). Such volatility targeting is a valid default rule for enhancing Sharpe ratios and reducing exposure to escalating crises. Effective volatility targeting and dynamic hedging can make use of options-implied volatilities, which not only help predicting future actual volatilities but also asset price correlations (view post here). High implied volatilities translate into high correlation whenever a single global factor is dominating price moves across all global markets.
  • Focusing on vulnerabilities: It is practically impossible to predict the timing and dynamics of systemic crises. However, it is possible to understand the nature of vulnerability in economies and markets. Through research in this field, asset managers can judge whether a specific shock is likely to be transitory or escalatory after it has occurredTwo important criteria for escalation risk are vulnerability and rarity.
    Vulnerability here means that a financial system has become reliant on favorable conditions. Typically protracted periods of low market volatility lead to build-ups of leverage and risk until they reach a tipping point (Minsky hypothesis, view post here). In particular, asset price surges combined with credit booms have historically given rise to ‘leveraged bubbles’ with policymakers struggling to contain the ensuing economic and financial distress (view post here). Also, economies that have grown accustomed to low real interest rates for long periods of time are subsequently susceptible to stress when rates or credit spreads are rising. Whether this stress is likely to escalate depends on whether there is a credible option of government or central bank intervention (view post here).
    Rarity means that the type of shock that has occurred had a low a-priori probability: it was not on the radar screen of either investors or policymakers. Theory suggests that senior decision makers rationally do not prepare for rare events as they can only process a limited quantity of information. Hence, expected losses from unpreparedness are inversely proportionate to an event’s rarity (view post here). Indeed, excepted losses from unpreparedness are even higher if managers bear only limited liability.
  • Running with the herd: Research may tell us that markets face a critical risk (e.g. a major bank may be at risk of default) but may not tell whether or not the risk will manifest (e.g. there may be a government bailout). Still, this information is helpful, because in “make-or-break” situations it is rational to herd, i.e. to trade in the direction of prices, as private information disseminates in the market (view post here). In this case, inaction would be an irrational and dangerous choice, even if we had no information advantage on the evolution of the crisis.
    Historically, simple trend following strategies have reduced maximum drawdowns in equity portfolios and provided some hedging against losses in FX carry trades (view post here). Trend following removes psychological and institutional obstacles to exiting positions early in escalatory crises.
  • Avoiding expensive liquidation: Market liquidity can evaporate in systemic crises. This can give rise to outsized price movements and, at the same time, make position adjustments prohibitively expensive. To the extent that liquidity problems rather than fundamental changes account for major market moves, position liquidation destroys investor value. Indeed, structural and regulatory changes in recent years seem to have made liquidity more precarious than in the past (view post here, here and here). Hence, calibrating or structuring positions such as to withstand liquidity events can be a major cost saver and performance factor. Researching the nature and potential of systemic risk is critical, both for preparation and for forming judgment whether or not it is really in the investor interest to liquidate positions in the thick of crises.

Investment managers can also benefit directly from systemic events to the extent that they have sufficient flexibility and risk limits to exploit price distortions and high risk premia paid. For systemic value based on price distortions see the related summary here. And for detecting and receiving high risk premia see section on “implicit subsides” here.

“Agents allocate attention so as to equate the probability-weighted expected loss due to suboptimal actions across contingencies. As a result, the expected loss due to suboptimal action in a contingency is inversely related to the probability of the contingency.”

Maćkowiak and Wiederholt, 2015

“Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side.”

Howard Marks, 2015

Calibrating tail risk

Standard risk management relies on past volatility of price changes, historic correlation, and assumptions regarding outliers of price changes beyond normal ranges. On this basis, the majority of portfolios of liquid financial instruments is managed based on some form of Value-at-Risk (VaR) model, a statistical estimate of a loss threshold that will only be exceeded with a low probability.

Unfortunately, past volatility is not always a helpful gauge for financial markets risk. Volatility is merely the magnitude of historic price fluctuations, while risk is the probability and scope of future permanent losses (view post here). The two are not equivalent and may even become opposites.  In particular, reliance on historic volatility can create an illusion of predictability that gives rise to carelessness in specific markets. Indeed, low volatility itself is often a cause of excessive leverage and crowded positioning and hence conducive to subsequent outsized market movements. One example can be seen in heavily managed currencies which may appear to have low historical volatility, a situation that can suddenly change when there are regime shifts.

Therefore, it is helpful to go beyond conventional risk metrics when assessing and calibrating the risk of large outlier events (“tail risk”):

  • Risk estimation must rely, at least partly, on expert assessment with subjective and non-quantifiable elements. For example, the risks and consequences of political upheavals, monetary policy regime breaks, or first-time sovereign defaults are not typically quantifiable through price history. A broad assessment of risk always requires a broad perspective, common sense, and an open mind.
  • There are also quantitative warning signs of increased “tail risk” other than volatility. The most plausible ones are valuation metrics, i.e. asset prices that are unusually high relative to estimated future cash flows. For example, academic papers have argued that equity markets with low dividend yields relative to local government bond yields are prone to large corrections (view post here). Similarly, countries with overvalued exchange rates and high short-term interest rates are prone to currency crises (view post here).
  • Volatility-based risk management metrics can be adapted for “tail events” and “gap risk”. Historically, diversification and downside risk analyses have assumed normal (“Gaussian”) probability distributions. Those are convenient for calculation but give little weight to large outliers. By now this “normality assumption” has been widely refuted and better gauges of tail risk are available (view post here), such as conditional Value-at-Risk. The distribution assumption is crucial for setting risk management parameters realistically and for assessing the potential upside of long-volatility and short-risk strategies.

“I don’t particularly care about the usual… Almost everything in social life is produced by rare but consequential shocks and jumps; all the while almost everything studied about social life focuses on the ‘normal’. particularly with ‘bell curve’ methods of inference that tell you close to nothing. Why? Because the bell curve ignores large deviations, cannot handle them, yet makes us confident that we have tamed uncertainty.”

Nassim Taleb, “The Black Swan: the impact of the highly improbable”

Exchanging market risk information

No single investor or institution has all pieces of the puzzle that is systemic risk. Investors specialize on markets or countries. However, every financial market depends on all other financial markets to some extent. At times particular market segments such as asset-backed securities or technology stocks can have a strong global influence. Even small and remote markets, such as Iceland or Greece have triggered sizeable global market moves in the past. These connections are due largely to the importance of global liquidity, which is the ease of financing transmitted by a small number of financial centers (view post here).

Therefore, investment managers must engage in active risk information exchange, trading their insights for the insights of colleagues. Indeed, theoretical and experimental research suggests that portfolio managers will generally share ideas and research if mutual feedback is valuable (view post here). This creates investor value at all times but particularly when systemic risk is rising, because investment managers that are part of an information network are better positioned to act early, as they know more and know better what others know. From a social welfare angle this process of information exchange is essential to disseminate concerns over systemic crises. The dissemination turn may serve to warn market participants, policymakers and the broader public, smoothing market volatility.

“Ease of global finance is driven by conditions prevailing in major financial markets, is transmitted internationally by globally operating financial intermediaries.”

IMF Policy Paper, 2014