Tail risk is a top concern for institutional investors, with close to half expecting a tail risk event, possibly due to asset bubbles (specifically oil price shock), according to the findings of the third annual Global RiskMonitor survey by Allianz Global Investors (AllianzGI).
When a portfolio of investments is put together, it is assumed that the distribution of returns will follow a normal pattern—that returns will move between the mean and three standard deviations, either positive or negative. However, tail risk assumes the distribution will be skewed, increasing the probability that an investment will move beyond three standard deviations.
Roughly two-thirds (66%) of the 735 institutional investors surveyed by AllianzGI think that tail risk has become an increasing worry since the financial crisis. The majority of respondents, though, rely on traditional asset-allocation and risk-management strategies to protect their portfolios, with 61% utilizing asset class diversification and 56% geographic diversification. With the inter-connectedness of markets, such diversification will become less effective in mitigating for drawdown risk, the firm says. Only 36% of respondents believe they have access to the appropriate tools or solutions for dealing with tail risk.
“The results of this survey reveal an important paradox: While almost two-thirds of institutional investors have become increasingly worried about tail risk events since the financial crisis, a far smaller proportion are confident that they have access to the appropriate tools or solutions to deal with such events,” says Elizabeth Corley, CEO of AllianzGI. “With the anticipation of more frequent tail risk events, there is an important role for active investment managers in helping clients to understand, classify, measure and ultimately mitigate the downside impact from these outlier events, as well as providing opportunities on the upside.”
Investors globally believe the most likely causes of upcoming tail events are oil price shocks (28%), sovereign default (24%), European politics (24%), new asset bubbles (24%) and a Eurozone recession (21%). Investors in the Americas and Asia-Pacific region express a stronger belief that oil price shocks will be the cause of the next tail event (35% and 28%, respectively), while new asset bubbles (33%), along with sovereign default (29%) and geopolitical tensions (29%), are considered dangers by investors in Europe and the Middle East.NEXT: Which asset classes do institutional investors favor?
Institutional investor asset class sentiment is polarized in relation to traditional asset classes. Investors are bullish towards European and U.S. equities and bearish on sovereign debt—developed and emerging market.
In terms of portfolio allocations, 30% of respondents globally plan to buy European and/or U.S. equities in the next 12 months due to their high upside potential. From a bearish perspective, 29% of investors say they will sell sovereign debt, and nearly one-third (31%) of investors are adamant that the asset class will fail to perform over the next year.
Among those bullish on equities, significantly more investors are enamored with European equities because of their high return potential (61%), compared with only 44% for those bullish on U.S. equities. A smaller proportion (20%) of equity bulls attribute their overweighting of emerging market equities to high return potential, citing diversification (18%) and hedge against inflation (18%) almost as often.
“The risk of a correction in the markets is growing with valuations continuing to rise, geo-political tensions festering and U.S. monetary policy tightening on the horizon. In general, institutional investors’ current asset allocations make sense, but the problem is that many of these investors are not incorporating the proper risk management tools to protect these investments from market volatility,” says Kristina Hooper, U.S. Investment Strategist at AllianzGI. “Risk assets are where investors should be in a time of financial repression, but their associated risks need to be well-managed.”NEXT: Help needed for better risk management.
Institutions are calling for better risk-management tools when investing in alternatives, without which the strong growth of this asset class could be stymied. Although three-quarters (73%) of those surveyed make broad use of allocating to alternative asset types already, 40% of investors said they would be keen to increase their allocation to alternative assets if they were more confident in their or their manager’s ability to measure and manage associated risk.
In particular, investors asked that asset managers focus on the measurement and management of liquidity risk rather than look to eliminate it. Around two in five investors (41%) believe there is a need for liquidity risk to achieve the best possible return and diversification benefits from alternatives.
Institutional investors continue to rely on traditional risk-management strategies, which could leave investors exposed to macro-economic and market shocks. Less conventional approaches that protect against downside risk, such as direct hedging and risk budgeting, are used by just more than one-third of investors (35% each), while liability-driven investing (LDI) and managed volatility strategies are employed by an even smaller percentage of investors (26% and 24%, respectively). Even though tail risk is a major concern for investors, fewer than three in 10 (27%) make use of strategies to hedge against tail risk.
Tail risk management is extremely challenging for many investors globally. Investors recognize the need for improvement to be better prepared for tail risk events, but 56% believe tail risk hedging strategies are too expensive. In addition, institutional investors believe that tail risks themselves (35%) and alternative products developed to manage them (36%) are not understood well enough.
To learn more about the report and to download global and regional findings, visit http://www.allianzgi.com/en/Risk-Management.