How to stress test portfolios to assess any impacts of continuing fallout from Brexit
Only last week saw global banks anxiously await the results of the latest European stress tests. The mixture of doubt and optimism, echoed by many, alluded to hopes that the bleak memories rising from the 2007-8 financial crisis remain safely in the past. For most under scrutiny, the results came as a relief, with the banks’ ability to weather financial turmoil up on results from previous years.
Yet banks are not the only ones who could see a benefit from ‘stress-testing’. Testament to their rigor and ability to withstand current financial climates, asset managers must undergo similar preparatory actions if they are to facilitate their continuing success. Highlighted by the UK’s vote to leave the European Union in June this year, there is no better time to ‘stress-test’ portfolios in the wake of economic uncertainty – for better or for worse.
Some would argue that extensive testing, similar to those undertaken by the banks, may not be entirely necessary – indicated by the recent shelving of the Financial Stability Boards’ stress-testing regulations. However, given the volatility rife within the financial industry, asset managers must install confidence in all parties through the water-tightening of investment portfolios, leading investors and asset managers alike to ask: How can investment portfolios weather the fallout from Brexit?
Keeping up with currency
On Friday 24th June, when the British people took to the polls to vote in their EU referendum, Sterling was heavily impacted by the vote to leave, selling off over ten per cent from the pre-vote highs to the US Dollar. With a continued and prolonged fallout, it would be safe to say that Sterling could come under further pressure. It is therefore of paramount importance to gain a thorough understanding of the potential impacts this may bring to a client’s portfolio.
A globally diversified GBP reporting portfolio should not be heavily impacted over the shorter term by a further sell off in Sterling; in fact most portfolios should be set to gain in the event of a further GBP weakening. Aligned to this, understanding where a client’s current and future liabilities are likely to be and in which currencies they are likely to be in, also plays an important part in determining how a client should invest.
Reducing a home country Bias
Understanding how much a portfolio will be impacted by further fallout will be mainly governed by how domestically orientated a portfolio is positioned. Investors in the UK, like many countries, suffer from a home country bias (see below), when the UK stock market only represents a small proportion of the overall global economy. Furthermore, a disjointed and disorganised UK exit from the EU will present opportunities to other countries and companies as a result.
Placing assets in different allocations
Brexit, if nothing else, has served us with a timely reminder that the old rules of ensuring that a portfolio is appropriately diversified provides valuable risk control – one of the most important contributors to ensuring a portfolio’s stability. The equity market sell off on Friday 24th June and Monday 27th June saw a spike in the prices of safe haven assets such as gold and government bonds. Advising on how a properly diversified portfolio should be structured requires an understanding of the individual client’s or families’ overarching risk appetite and the risk budget that they feel comfortable utilising at this time in the market. The two may not be necessarily the same and some clients may feel less inclined to utilising all of their risk budget at this time and are happy to sacrifice some of the potential upside.
The chart from Vanguard below illustrates the impact on the expected range of returns from moving up the risk curve.
Having the right investment manager mandates
Investors should look to wealth advisory companies that are uniquely placed to assist in the independent appointment of best in class discretionary managers. This allows them to monitor discretionary managers on an ongoing basis and assess the tactical decisions that they make. Upon this core philosophy has always been that tactical asset allocation is a major, if not the main, contributor to investment return to ensure that the risks associated with it are diversified and not concentrated to any one discretionary manager or institution.
In times of market disruption having different managers with flexible mandates to react and reposition the underlying holdings immediately can add (or protect) significant value. Ensuring that the tactical decision-making on a client’s portfolio is adequately diversified across best in class discretionary managers with the mandates required and flexibility to react to market disruption, which can significantly de risk the overall portfolio and add alpha.
Any stress testing must include scenarios customised to your personal portfolio and be aligned with your investment strategy. This should include risks applicable to the industries, funds and assets you have invested in. Asset managers should ensure that their testing includes dummy effects, to mimic global uncertainties and exposures that are inevitable in our unpredictable climates.
Increasing cost efficiency
Finally, in a low growth environment, ensuring that a portfolio is being run in the most cost efficient way possible will be an important factor to ensuring investment success. You should trim unnecessary costs and fees to help reduce your portfolio’s expenses to a minimum. This does however need to be balanced with the need to employ high quality managers to navigate through any market disruption while the UK negotiates its exit from the EU.
The Brexit vote has shone light on potential investment vulnerabilities globally, from banks to individuals. Whilst the UK’s vote to leave the European Union is a unique scenario with global implications, not all economic conditions will have the same reach and impact – thus testing must be thorough, adaptable and regular to ensure the greatest protection for assets in the years to come.
Alistair Peel, Executive Director