It is true that over-all fiduciary risk is often thought of as the risk of not following proper fiduciary standards. As this blog has often noted, a proper fiduciary process means adhering to the 21 Practices and 82 Criteria in the Global Fiduciary Standard of Excellence (GFSE); see fi360 and the Centre for Fiduciary Excellence for more information.
Practice S-2.2 of the GFSE states “An appropriate risk level has been identified for the portfolio”. Once identified, how do we monitor portfolio risk on an ongoing basis? Practitioners of Modern Portfolio Theory (MPT) argue that the quantification of risk based on historical measures is the best approach. However, aren’t there risks which are outside of the world of the MPT soothsayers that we need to consider?
We see five main areas of risk affecting investment portfolios which should be considered when looking to the future:
Rise of global nationalism: While we face a possible populist presidency in the US, the resurgent nationalist sentiments sweeping across parts of Europe could cause an increase in politics-driven market volatility and pose more trouble for the fragile euro zone over the short-to-medium term.
Asymmetrical warfare: The newest battlefield reflects asymmetrical warfare; the number and size of cyber attacks are growing exponentially. Unlike traditional warfare, cyber attacks can take down entire power grids or disrupt manufacturing from a thousand miles away. We have already seen how private hackers and nation states have attempted to disrupt our economy and hijack our political process.
Uncertainty regarding life after Brexit: When Brexit was first announced, the markets plunged and then recovered nicely. Since then we have seen the global markets show strong returns. However, as the recent fall in Sterling has shown, the reality of Brexit has unmasked tensions in the UK between those who favor a soft exit and those who prefer a hard exit. So, too, has anxiety risen in the EU as to what may happen when/if Article 50 of the Treaty on European Union is triggered.
Softness belying the strength of the global capital markets: We probably can agree that the current bull market has been one of the longest if not the longest bull market in recent decades. Forward P/E ratios for the S&P have risen to 18.42, well above the post 1980 average. The current P/E Ratio of 25.59 is higher than it was at its peak in 2000. This would be OK if operating EPS had also risen or remained flat; however, EPS have shrunk for the first two quarters in 2016. Margin compression continues to be a concern with more than half of the S&P 500 showing declining margins. The same logic may be true for most other developed markets as well.
Expected rise in US Interest rates: There has been much speculation over the last few months (and indeed the last year) as to when the FOMC will raise interest rates. With a negative term premium rate (a term premium is the extra return that lenders demand to hold a longer-term bond instead of investing in a series of short-term securities), a rise in interest rate expectations may lead to higher Treasury yields. Rising short-term rates may help with the value of the dollar but put further pressure on corporate profit margins. A stronger dollar could have a negative impact on the balance of trade and corporate earnings. The New York Fed’s trade model suggest that a 10% appreciation in the dollar would reduce the annual US GDP growth rate by 60 bps for the next two years.
These five issues, the rise of global nationalism, asymmetrical warfare, uncertainty regarding life after Brexit, the softness belying the strength of the global capital markets, and a probable increase in US interest rates are but a few of the issues fiduciaries need to consider when planning for the future. Fiduciaries have an ethical and moral obligation to use their expertise for the benefit of their constituents. This means, amongst other duties, periodically reviewing their asset allocation assumptions and adjusting their portfolio’s equity exposure when needed.