The history of investing is full of examples of how a few extra basis points in potential returns can be overshadowed by unexpected drawdowns when volatility surges. Understanding and controlling risk is the bedrock of appropriate investment decision-making. A breach in risk thresholds should never be accepted in the name of promised higher returns.
Since the financial crisis of 2008, money managers and their clients have faced a drought of income returns as central banks around the world cut interest rates to record lows. Investors are getting minimal rewards from the safest securities, and are therefore being pushed up the risk scale in their search for yield.
While the jury is still out on whether policymakers have been successful in boosting economic growth and inflation, low interest rates have left a lasting mark on the asset management industry. Investors have been forced to redraw strategies and venture into new territories as they embrace more volatile securities.
Venturing into these new territories, and in turn increasing the risk profile of a portfolio, means raising the potential for drawdowns (falling values). At Santander Asset Management we believe unexpected losses can, and should, be avoided. Working within a pre-established risk profile is the top priority for the Atlas Portfolio range. There are at least four types of risks that should be taken into account in the search for yield:
- Duration risk: comes with longer-dated bonds that are more vulnerable to changing interest-rate expectations and hence more volatile.
- Credit Risk: attached to higher-yielding but lower-rated bonds, which are susceptible to larger drawdowns during a deterioration of the economic environment or investor sentiment.
- Liquidity risk: embedded in higher-yielding assets that are either less liquid or don’t have daily pricing, these may prove hard to sell.
- Complexity risk: investments whose high returns are based on structures or strategies that are not easy to understand. These may mask volatility and potential losses that only become visible when it’s too late.
Lessons learnt in the financial crisis around governance and understanding investments still resonate. As credit spreads widened and default ratios increased, many high-yielding securities proved costly, and in the worst cases, impossible to sell . Certain complex derivatives structures that had been billed as safe fixed-income products, ended up being toxic assets – a prime example of complexity risk.
So how does Santander Asset Management navigate a world of low yields? Especially when the possibility of meeting returns targets is intrinsically linked to taking on more risk.
The key is to aim to maximise returns but within the parameters of well-defined risk profiles and volatility tolerances.
Having set a realistic income target for the Atlas Income Fund, our driving principle is to take a diversified approach to income enhancement. Our team utilises multiple asset classes and varying managers to diversify the portfolio and manage risk. e use various traditional strategies, such as investing into high yielding equity funds, controlled allocation to duration, and higher yielding corporate bonds, as well as selling exchange-traded options, to deliver our income target. All of these are based upon compliance with our liquidity and risk tolerance parameters. Diversifying assets ensures the fund is not dependent on one source.
Our governance monitoring and initial due diligence process helps to minimise the duration and credit risks mentioned earlier. We control liquidity risk by ensuring that we only hold investments that are daily priced or traded. This avoids illiquid vehicles that are slow or difficult to disinvest from. Finally, the fund management team deals with complexity risk by conducting extensive due diligence before making investment decisions, following this up with continuous monitoring of the strategies and funds that make up the portfolio. This is carried out by both the fund management team and, of course, audited by an independent global compliance team.
Discipline is of the utmost importance, we have a fiduciary responsibility to clients, and that is the ultimate responsibility.
For terms and condition and to find our more about Santander's products please visit www.santanderassetmanagement.co.uk