Understanding risk and its effective management

1
Understanding risk and its effective management

• Romeo Makhubela
• CEO

2
Agenda

• Introduction what is risk?
• 3 big picture concepts
• Time
• Fund dynamics
• Regime switching.
• Conclusion

3
What is risk?

• Its all about perspective

• Institute of Risk Management considers
• Uncertainty (travel arrangements)
• Danger (skydiving)
• Probability (SA to win Rugby World Cup 2011)
• Variability (buying a lotto ticket)
• Dread (shark attack).
• Peter Bernstein in his book Against the Gods
  the Remarkable Story of Risk demonstrates a
  perspective that requires one to
• define what may happen in the future and choose
  among alternatives.
• he states that risk should not be feared, and
  goes hand in hand with challenge and opportunity.

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What is investment risk?

• Investor Words definition

• The quantifiable likelihood of loss or
  less-than-expected returns due to
• Currency- Interest Rate-
• Inflation- Equity-
• Principal- Credit-
• Country- Unsystematic-
• Economic- Call-
• Mortgage- Business-
• Liquidity- Counterparty-
• Prepayment- Purchasing power-
• Opportunity- Event-
• Income-
• .RISK

What factors are in play that can derail the
expected outcome?
5
Some commentary

• Risk is the future uncertainty of a current
  decision.
• To be make money, we need to be exposed to it.
• How much we can tolerate depends on
• how financially wealthy we are,
• what we are trying to achieve, and
• how much time we have to wait.
• It is the amount of exposure to risk, of the
  right kind, that determines success or not but
• Risk is NOT independent of expected return.

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Risk acceptance

• 3 big picture concepts that impact ability to
  assume risk

• Time
• As a general rule of thumb, the longer the time
  to ones target date, the more aggressively one
  can invest.
• Fund dynamics
• one solution does not fit all requires
  migration through complementary solutions
• risk management solutions can no longer be
  static.
• Prevailing environment (Regime switching)
• within this dynamic solution, one must respond to
  differing market environments.

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Time Equity returns are uncertain...
over the short term
00 01 02 03 04 05 06 07 08 09
1900 15 18 4 -7 22 -20 15 -11 41 30
1910 -14 -15 7 -6 -12 7 12 -3 6 33
1920 -43 2 76 10 17 16 25 8 2 -2
1930 -7 -6 34 113 33 17 28 -20 1 -7
1940 0 16 -3 19 8 22 -4 -13 -9 25
1950 -10 -1 -8 0 18 -7 -6 -4 19 32
1960 -2 10 27 22 15 4 16 18 48 -14
1970 -30 2 52 -4 1 -22 -12 18 23 70
1980 21 -12 22 3 -3 20 33 -17 2 35
1990 -17 13 -11 41 12 2 0 -10 -16 51
2000 -7 21 -17 11 20 41 34 10 -32 22
2010 14
1 year real returns
data annual total return and inflation data from
1900 to 2011
data source Prof C Firer annual data 1900 2008
8
Equity returns...
exceed inflation over almost all periods of 10
years or longer
00 01 02 03 04 05 06 07 08 09
1900 9
1910 6 3 3 3 0 3 2 3 0 1
1920 -3 -2 3 5 8 9 10 11 11 8
1930 13 12 9 17 18 18 18 15 15 14
1940 15 17 14 7 5 5 2 3 2 5
1950 4 2 2 0 1 -2 -2 -1 2 3
1960 3 4 8 10 10 11 13 16 18 13
1970 9 9 11 8 7 4 1 1 -1 6
1980 12 10 8 9 8 13 18 14 11 9
1990 5 7 4 8 9 7 4 5 3 4
2000 6 6 5 3 4 7 10 12 11 8
2010 11
10 year real returns (rolling annualised)
data annual total return and inflation data from
1900 to 2011
data source Prof C Firer annual data 1900 2008
9
Bond market returns
are driven by inflation
00 01 02 03 04 05 06 07 08 09
1900 16 -6 0 10 11 9 12 4 8 -1
1910 -11 1 0 1 3 -15 -7 -5 2 -7
1920 -20 25 28 6 4 6 7 5 6 5
1930 6 9 3 35 8 9 3 -4 -1 0
1940 2 4 -3 -1 -1 2 6 -3 -9 -3
1950 -5 -9 -10 4 4 -3 1 1 -4 5
1960 2 -2 20 3 -2 -10 -4 5 4 3
1970 -11 -6 5 0 -17 -6 -8 3 9 -1
1980 -19 -10 16 -13 -10 -6 15 0 -4 6
1990 1 -2 17 21 -17 22 -3 22 -4 27
2000 12 14 4 18 10 8 0 -4 7 -7
2010 11
1 year real returns
data annual total return and inflation data from
1900 to 2011
data source Prof C Firer annual data 1900 2008
data source Prof C Firer annual data 1900 2008
10
Bond market returns
stay negative in real terms for long periods as
inflation rises
00 01 02 03 04 05 06 07 08 09
1900 6
1910 3 4 4 3 2 0 -2 -3 -3 -4
1920 -5 -3 0 0 0 2 4 5 5 6
1930 9 8 6 8 9 9 9 8 7 6
1940 6 5 5 2 1 0 0 0 0 -1
1950 -1 -3 -3 -3 -3 -3 -3 -3 -2 -2
1960 -1 -1 2 2 2 1 0 1 2 2
1970 0 0 -1 -2 -3 -3 -3 -4 -3 -3
1980 -4 -5 -4 -5 -5 -5 -2 -3 -4 -3
1990 -1 0 0 3 2 5 3 5 6 7
2000 8 9 8 8 11 9 10 7 8 5
2010 5
10 year real returns (rolling annualised)
data annual total return and inflation data from
1900 to 2011
data source Prof C Firer annual data 1900 2008
11
Cash returns
are not the perfect hedge against inflation (even
before tax)
00 01 02 03 04 05 06 07 08 09
1900 0 -5 1 13 9 10 11 5 4 -3
1910 -11 -1 1 2 2 -1 0 -4 -3 -6
1920 -14 16 23 6 2 3 5 2 3 3
1930 6 6 9 4 -1 1 0 -2 -3 -1
1940 -4 -6 -8 -5 -4 -1 -2 -4 -6 -3
1950 -6 -7 -5 1 -2 0 1 0 0 0
1960 2 3 2 1 -1 2 1 4 3 2
1970 2 1 0 -4 -3 -2 1 -1 -2 -7
1980 -9 -1 4 4 7 3 -5 -4 1 3
1990 5 2 6 3 1 7 6 11 10 8
2000 3 4 1 8 4 3 3 1 1 3
2010 3
1 year real returns
data annual total return and inflation data from
1900 to 2011
data source Prof C Firer annual data 1900 2008
12
Cash returns
over the short or long term
00 01 02 03 04 05 06 07 08 09
1900 4
1910 3 4 4 3 2 1 0 -1 -2 -2
1920 -3 -1 1 1 1 2 2 3 4 5
1930 7 6 5 4 4 4 3 3 2 2
1940 1 -1 -2 -3 -3 -3 -4 -4 -4 -4
1950 -4 -5 -4 -4 -4 -3 -3 -3 -2 -2
1960 -1 0 1 1 1 1 1 1 2 2
1970 2 2 1 1 1 0 0 0 -1 -2
1980 -3 -3 -2 -2 -1 0 -1 -1 -1 0
1990 2 2 2 2 1 2 3 5 6 6
2000 6 6 5 6 6 6 5 4 4 3
2010 3
10 year real returns
data annual total return and inflation data from
1900 to 2011
data source Prof C Firer annual data 1900 2008
13
Asset class risk vs time
Equities deliver higher returns but with
exponentially higher risk over the short term
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Fund dynamics

• Risk management solutions can no longer be
  static.
• Consider a closed pension fund with members with
  characteristics differing by
• age
• retirement date
• gender
• contribution value
• tax rate
• accumulated benefits.
• The solution for the retirement fund as a whole
  is driven by the aggregate cash flows, which
  include contributions (by active members) and
  withdrawals by retired members.
• This solution is not simply 100 allocation to
  one fund, to and from which contributions and
  withdrawals are made.

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Dynamic solution superior
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Regime switching

• Economic cycles, a starting point

normal
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Economic cycles

• need to be viewed in three distinct states

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Temporal adjustment

• to the long term SAA to reflect the dynamics of
  each macro environment

Equity Bond Cash Con 13 27 60 Mod 26 19 55 A
gg 35 15 50
Equity Bond Cash Con 29 29 42 Mod 50 25 25 A
gg 65 15 20
Equity Bond Cash Con 40 32 28 Mod 64 27 9 Ag
g 75 20 5
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Combining time, dynamics environment

• value add

Statistic Balanced (Static) Balanced (Risk mitigating) Balanced (Opportunity seeking) Balanced (Regime switching)
Annual Return 16.2 13.3 17.0 17.9
Annual stdDev 10.8 6.2 13.2 10.5
Sharpe ratio 0.7 0.7 0.6 0.8
Maximum Drawdown -19.3 -8.1 -25.7 -13.4
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Conclusion

• Risk is the future uncertain outcome of a current
  decision.
• Especially in the new millennium, three important
  facets to recall and consider are time, fund
  dynamics and regime switching.
• Time in the markets is a management tool.
• Static solutions no more.
• Regime switching, as a critical component of the
  dynamic solution.

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Questions?
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Regulatory information
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