The importance of top-down funds management

Patrick Farrell discusses the importance of top-down management and the current risk environment in funds management.

Top-down management focuses on large global issues that have the capacity to affect the dynamics around future financial market behaviour.

Assessing these impacts is an important discipline when constructing an efficient investment portfolio.

At times of downturn such as these, markets are driven more by sentiment than fundamental reasoning, leading to the emergence of some excellent investment opportunities.

While such opportunities are being created, it is crucial to remain cognisant of the risks that develop with these opportunities, as there have been substantial changes to the way companies, as well as governments, regulators, central banks and investors, operate.

For example, financial institutions around the world have been instructed to review incentive packages for executives, not only to focus on driving shareholder returns, but to also include risk management strategies.

This impacts significantly on the risk appetite that financial companies are prepared to assume.

Risk management is inherent in every decision we make — from portfolio construction through to ongoing reviews.

Our process adds an additional layer of risk management to manage the overall exposures and eventual impact on a client’s portfolio.

When setting strategic asset allocations, we don’t just focus on historical data, we also look to our top-down analysis to forecast risk and return for the next 10 years. We look at multiple potential risks that can affect an investment portfolio and manage them accordingly.

• Market risk — diversifying across sectors, countries, managers and investment styles.
• Style-bias risk — blending lowly correlated complementary managers via direct mandates.
• Manager-specific risks — maintaining a combination of managers who are closely and regularly monitored.
• Specific event risks — Stress testing portfolios for events that have a low probability of occurring but would have a significant impact on portfolios.
• Liquidity/transparency risk — managing asset classes that don’t provide sufficient liquidity or transparency (ie, unlisted property, private equity and infrastructure) in order to allow investors continual access to their money.
• Capacity constraints — by selecting managers who are prepared to reserve funds under management so the fund can maintain its objectives.

Geo-political risk and the role of commodities

Geo-political risk is a hot topic at present, with emerging markets making waves that affect the wider global markets.

In times of crisis, governments generally look to protection-type strategies and policies to secure their domestic industries (ie, government bailouts for local industry and increasing trade tariffs). While this may help domestic growth, it affects the flow of capital and the global trade environment that can increase tension in an already stressed economy.

There are obvious tensions building in areas such as the Middle East and sub-Saharan Africa. Energy distribution (balancing the supply/demand equation) is one of the most pressing issues.

The countries that need oil are bargaining with those that have reserves in order to guarantee future supply, which causes tension in other ways.

Any potential conflicts that may arise, especially in oil rich regions, can have a dramatic impact on financial markets and in particular on key commodity prices.

On the back of this, we believe commodities play a dual role in managing portfolio risk. Commodities are supported by the positive structural change in the global economy — particularly in emerging markets such as China and India.

Advance increased its exposure to commodities in January to capitalise from the cyclical fall in prices. Global macro risk management is provided through such means.

Commodities also provide a level of protection for the portfolio in the event a political conflict arises that would have a sharp impact on energy prices.

Inflation protection is provided through commodities when supply-constrained price increases feed into headline and then core inflation.

Patrick Farrell is head of investment solutions at BT Financial Group.