Risk Management: Did fund managers learn their lesson?

By Detlef Glow, Head of EMEA Research at Lipper. The views expressed are his own. In the last decade investors and fund managers faced two major crises in the stock markets, the popping of the technology bubble in 2001 and financial crisis starting in 2006. Portfolio managers suffered average losses of about 50 percent in the wake of both crises, leading investors to question what their fund managers learned. A Lipper and Avana Invest study on the maximum drawdown of actively managed funds found that those fund managers must have introduced new risk management tools after the bust of the technology bubble. Still, they failed to meet investor expectations on managing risk. The changes led to smaller tracking errors, but the funds suffered nearly the same losses shown in their respective markets during the 2006-2010 financial crisis. The study by Lipper and Avana, a German asset management boutique firm, found that portfolio managers started a risk management system that measured relative risk compared to their benchmarks instead of measuring absolute risk in terms of losses. The new management guidelines did not meet the expectations of private investors and led to the following conclusions:  Relative risk management systems are penalizing fund managers if their risk compared to the benchmark moved above a defined level. The study found that a fund manager was not allowed to hold a high percentage of his portfolio in cash or decrease the weighting of a specific industry to zero, as this would increase the risk of the portfolio relative to the benchmark. As a result, managers moved their allocations closer to the benchmarks in market downturns to avoid penalties. Conversely, if a fund lost 45 percent, while the respective benchmark had lost 50 percent, for example, the fund manager could be rewarded for his outperformance, even as he lost money for investors. The study — which covered the 2001-2005 tech bubble and the 2006-2010 financial crisis for all active managed funds registered for sale in Germany in the equity peer groups Asia/Pacific, Europe, North America and global — showed that the markets, measured by the movements of the broad market indices, exhibited similar drawdown losses in the different regions during both periods. The maximum drawdown measures the loss in percent for an investor, who bought a fund at the highest price and sold it later at the lowest price during the evaluation period. This result was not surprising, since risky assets tend to narrow their correlations and therefore move in the same direction during such periods. Opposite of the markets, the analyzed funds showed a different behavior over the periods. Since the general results in different regions showed the same picture, a look at European stocks offer insight into what was happening in the other regions. For this reason all of the mentioned results are based on the peer group Equity Europe. During the tech bubble, a number of actively managed funds in the Equity Europe category showed much smaller losses than the markets did, but because other funds showed much higher losses than the markets, the average return of the analyzed funds was below the market average. The analyzed funds showed much lower variation compared to the market benchmark during the 2006-2010 financial crisis. These findings lead to the assumption that the asset managers tightened the risk budgets of the funds and gave the fund managers stricter guidelines in terms of acceptable risks they could use to outperform the benchmarks. As a result of these new paradigms, fund managers started to track their benchmarks even more closely during downturns. What does this mean for investors? Investors should only buy funds that suit their needs in terms of risk adjusted returns and the capability to preserve capital. The asset management industry needs to regain investors’ confidence by following the demands of the investors for risk management in absolute instead of relative terms. This means fund managers should start to hold cash or other risk free assets during downturns. Otherwise, investors may start to allocate even more money to pure-beta instruments such as exchange-traded funds. Second, fund managers can find superior returns by using multiple asset classes or alternative strategies like covered call writing for their allocations. Finally, in times of crisis and market downturns, fund managers should become more active instead of passively tracking their benchmarks.