A new study from Fidelity Worldwide Investments and Greenwich Associates reveals that key institutional investors across Europe are abandoning the concept of a risk-free rate of return as one of the foundations of portfolio construction. With this basic element of modern portfolio theory increasingly irrelevant, institutions have lost one of the anchors they have relied on to set stable investment policies. In response, institutional investors and the investment managers who advise them are developing new frameworks to guide their investing in a changed world.
The crisis of confidence in the idea that sovereign country debt in a home currency is risk-free is unsurprising. The threat of default on Greek government bonds and the potential contagion to larger countries like Italy and Spain has introduced an unusual degree of risk to sovereign debt in the Eurozone. When Standard & Poor’s downgraded U.S. government bonds earlier this year it raised the spectre of even the most reliable government borrower defaulting. Investors continue to treat theUnited States as a safe haven in the current crisis, but beneath the surface long-term inflation worries as a consequence of American monetary decisions have caused some investors to drop the dollar as a reference currency, particularly in Asia our study reveals. These investors fear debt will be repaid in future dollars worth much less than the ones supplied today—in effect a stealth partial default.
With confidence in old frameworks diminished, institutional investors are adopting new approaches and new strategies to control their portfolios. In addition to assessing Value at Risk, they are running complex simulations and assessing maximum drawdowns so they can limit the absolute losses they are likely to experience in a crisis. They are also challenging the investment managers who advise them to develop new, low risk structures that they can rely on.
The money of some countries once considered peripheral are suddenly being treated as reserve currencies, less likely to suffer devaluation from short-term shocks or long-term value erosion. Corporate credits once deemed riskier than sovereign debt are now perceived as better bets where cash flow is strong and balance sheets sound. The investment industry is on the verge of producing new indices composed of a different blend of best issuers than the ones that have traditionally dominated institutional investment markets. No one non-traditional currency can provide the liquidity institutional investors need, but a basket of government bonds from responsible developed economies and strong emerging ones plus prime corporate credits offers promise.
The stage is being set for a sea change in how institutional investors think. For generations we were trained to believe that developed economies would grow slowly and steadily with modest peaks and troughs in their business cycles as they headed generally upward. Major developed country sovereign debt was the lowest risk category available to provide stability to investment portfolios. Emerging markets would generate high growth, but with violent swings bound to distress even steely nerved investors. Default risk in dollar denominated sovereign bonds, as evidenced by periodic Latin American and Asian debt crises, remained real.
Yet, the current state of affairs suggests major emerging markets are poised for continued steady expansion at a time when the major developed economies appear headed for an extended period of slow growth or recession. The IMF projects a 4% gap in growth between rich countries and emerging ones next year. The momentum in emerging economies is likely to be slower over the next decade than during the last one since they have absorbed a healthy measure of rich-world technology already, and the large ones have reached the middle-income stage when growth becomes harder. Yet, the emerging economies do not have the debilitating debt and deficit problems the world’s largest rich economies are suffering. And at the moment emerging country governments are demonstrating more political will to pursue sound pro-growth policies than the Eurozone countries, the United States or Japan. Emerging economies suddenly appear to be the reliable ones.
The crisis we are experiencing will leave casualties behind. Likely among them will be the assumption that a risk-free rate of return exists that can be used as the starting point to construct portfolios. In its place will be a more sober assessment of investment risk, and new benchmarks that give pride of place to the debts and currencies of a new blend of responsible countries and well-run companies. The world we invest in is changing.
(Chris McNickle is the Global Head, Institutional Business, Fidelity Worldwide Investments)
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