Investment Lessons So Far
Patricia Hudson: We all remember Warren Buffet’s remark during the GFC that “when the tide goes out, you learn who has been swimming naked.” What have we learned or re-learned this time about areas of vulnerability that might change investor behavior or preferences?
Rick Lacaille: I think we’re still too early in the story to say, but we know that there are potential vulnerabilities among those companies and investors that are highly levered. Many companies have loaded up on debt because interest rates have been so low; similarly, I am sure we will see challenges with some investors who have been overly confident about the volume of illiquid assets in their portfolios.
Another area of vulnerability we will see in time involves aggressive accounting to obscure some real underlying cash flow problems. Think about the oil hedges that have gone wrong as prices have crashed: a lot of market participants have hedged their future consumption of oil and have lost a great deal of cash flow meeting margin payments. Those problems might not be readily apparent now, but they will eventually emerge, whether with an insurance company or an asset owner or a company like Metalgesellschaft in Germany, which ran into huge difficulties with its energy hedges in the 1980s.
In emerging markets, there will likely be some big problems where the dollar mismatch is material and some emerging market debt will be mispriced, leading to losses. But we believe a large number of emerging market issuers will be able to navigate the current crisis without defaulting. The question is the extent to which those individual defaults might cascade to developed market and emerging market investors.
I also think investors will see a number of opportunistic buying opportunities as distressed funds are launched. We are engaged in discussions with clients about those possibilities, but there has been little money in motion so far.
Lori Heinel: It’s likely that the work-from-home realities have made it more difficult for asset owners to consider big opportunistic moves. Among our larger clients, they have investment staff who are speaking to us about the opportunities, but they want to do their own analyses.
Consultants are also processing what is the best way forward. Still, the discussions we are having today with clients and consultants will be vital for helping them take action, once they have restored a semblance of normal working conditions.
I agree with Rick that the jury is still out on a number of asset classes, including private equity and private real estate. Commercial Class A office space used to be almost a non-brainer for investors from an income perspective, but will that still be the case as companies reconsider their real estate footprints?
I do think we can identify several lessons re-learned in this crisis. Foremost are abiding lessons around good governance and ensuring you have the right protocols in place around processes and decision rights so that you can act quickly and effectively. For example, what needs to be done when a significant number of investment-grade debt issuers become fallen angels? Is portfolio rebalancing explicitly mandated in investment policies?
Cyrus Taraporevala: For a number of smaller plans, I think the crisis has reinforced questions around whether they have the governance and structural wherewithal to make decisions in a rapidly evolving market environment. If their investment committee is meeting only four times a year, do they need to consider an outsourcing solution for their governance, either a rules-based set of triggers that will kick in without subjective second-guessing, or indeed a full-fledged OCIO solution where they can ensure that governance is in the hands of professionals who can take those decisions efficiently?
The crisis has clearly also underscored the benefits of working with managers who can provide ready access to liquidity and facilitate transacting even during the height of market volatility, with an expert view on when and how to execute.
Another renewed area of focus for asset owners will be the resiliency of their technology systems and operations when it comes to such a radical transformation in working conditions. We have all talked to clients about business continuity and operational resiliency in the case of natural disasters or cyber attacks, but this was an entirely new order of magnitude. Nonetheless it does raise important questions around scenario planning and stress testing.
Rick Lacaille: We are already seeing a number of questions around capital efficiency versus capital resiliency, both for corporate balance sheets and investment portfolios. As long-term investors and risk managers, we know that essentially, this is a question of balance. By definition, you cannot prepare for unknown unknowns and therefore tail risk management will always be an approximation.
Lori Heinel: As we have all said, there is much more of this story to unfold and long-term behavior doesn’t change as the result of a single quarter. However, we might see a different level of stress testing at the portfolio level in terms of what it means to be truly diversified and prepared for a wider range of market scenarios. I suspect investors will retain more working capital in future, less as an asset allocation decision and more as a true liquidity buffer, because no one wants to be a forced seller at the worst possible time.
Cyrus Taraporevala: Frankly, the biggest area of vulnerability for investors is not knowing how much longer this crisis will last. If in a year or two, large sections of the economy are still closed because of renewed waves of the virus and the market is gyrating up 20 percent and down 20 percent, then that will dramatically exacerbate existing vulnerabilities and create new ones. As many economists have said, the magnitude of the economic downturn is less damaging than its duration, and we just don’t know how long that will be. The one thing we do know is that we will eventually emerge from the crisis; until then, we will continue to partner with our clients to ensure they have access to the insights, expertise, and liquidity they need to navigate the challenges to come.