The success of an institutional investor depends on a number of variables. Planning has its limits, as the investor is always at the mercy of the markets. Forecasts only go so far because they seldom come true. Recently, when giving a presentation, I was asked whether the covid-19 crisis has affected my thinking about investing. Has the corona crisis given any new ideas?
It’s now three months since the pandemic started. Nobody knows if this is it, or if it will go on for years. Given the variation range, it’s too early to sum it up. The time for conclusions will come later, but hopefully not too late. For instance, a study analysing the link between the Spanish flu (1918-1919) and air pollutants was published recently, 100 years after the epidemic.
But some observations can already be made at this point. What first comes to mind is how little has actually changed. Here is a list of things that have changed as well as a list of things that have not:
1. The institutional investor is at the mercy of the markets
The changes caused by the crisis in the marketplace are remarkable. A big institutional investor is often unable or unwilling to change its asset allocation in the middle of a crisis. An investor cannot escape the movements in the marketplace. Consequently, the acceptable level of risk is determined beforehand. The actions taken in the middle of a crisis could also be important for some investors.
2. Risk management may be misunderstood
People often think that risk management helps get rid of investment risks. It’s an illusion. For an investor, risks are something that must be taken in order to earn sound returns. Risk management, in turn, means that the risks are correctly attuned to what one wants to achieve. Risks must be identified and converted into numbers. Risks need to be ‘stress-tested’ to see how the portfolio would fare in a hypothetical crisis. Are we satisfied with the results? Moreover, risk management compels the investor to continue to spread risks.
3. Timing is always difficult
Crises in the financial markets evolve in stages. It may be possible to exit the investment market in time, before the crisis hits. One can only congratulate those who manage to do so. However, the biggest compliments go to the investors who succeed in re-entering the market at the right time. Since investing is complicated, you can also achieve a satisfactory outcome by avoiding the biggest mistakes.
4. The problem with risk reduction is that it may actually increase risks
If an investor stays away from the biggest bull markets, it may miss out on major returns. Sometimes the biggest rallies take place in the midst of a crisis. Such a reversal, at least the first one, was experienced at the worst moment of the crisis on 24 March 2020.
5. The worst that can happen is a recession lasting several years
For an institutional investor, the least appealing scenario is a prolonged recession with weak economic growth and poor financial performance by companies. No wonder central banks and governments are working hard to prevent it from happening.
6. You need to be humble before the markets
Market movements are often surprising. It’s hard to be better than others in a highly competitive market. The most important thing is that the institution’s risk level is correctly attuned to its objectives and activities.
7. It’s hard to predict the timing of countermeasures
In the current crisis, the countermeasures taken by the central banks were timed unexpectedly. Decisions were not taken at pre-scheduled meetings: they were made on a timely basis in between meetings by making use of the element of surprise. Government action, by contrast, often materialised gradually following a public debate.
However, the current crisis is primarily medical. We still lack a definite idea of the progress of the disease. Any news of a vaccine shakes and rattles the markets.
8. Timeframe for liabilities?
Each institution has its own timeframe for liabilities. This timeframe or related computation technique determines what needs to be done and not done over the short term.
9. Combination of strategies
The two main active strategies available for the investor are ‘contrarian’ or ‘momentum’. A contrarian investor believes in mean reverting markets to normal path. Most likely, all investors make use of both. Unfortunately, there is no one right answer as to which of these strategies is better, and it even changes with time. Many investors, such as the Norwegian Pension Fund, which pursue an investment policy based on reference indexes, are compelled to combine ‘contrarian’ and ‘momentum’ investing. A momentum investor would perhaps have exited the market during the coronavirus crisis but would probably not have returned in time. A contrarian investor would probably have bought assets cheaply but would have suffered as prices fell.
10. Continual improvement
The current crisis will leave its marks. Every institution learns something new about how to develop its earning potential and risk management in the future. There is always room for improvement.
To summarise, it is safe to say that very little has changed. With markets, timing is always challenging. For this reason, a sound basic allocation is the best policy for achieving long-term objectives. The main thing for any institution is, however, to achieve the purpose for which it was created. For pension funds, the mission is clear.
The writer is VER's CEO Timo Löyttyniemi.
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