- Co-Head of Investment Strategy
United Kingdom, Professional
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In early 2008, I was part of a dedicated new risk group at Wellington that was focused on looking at markets from a factor perspective, identifying what our investors needed to know, and encouraging the use of stress testing before it had really come into fashion. As it turned out, the market was just about to face a stress test for the ages, with the collapse of Bear Stearns and all that followed. While today’s market faces a different set of tests, I think much of what we learned in 2008 is once again very relevant.
Over the course of 2008, the message to investors evolved
Using our factor lens, the main point we conveyed to investors in early 2008 was that while markets were uniformly down from a region, growth, and value perspective, factor positioning mattered. Regardless of how a market shock starts, we noted, if the process continues beyond the original event, then one should expect high-beta and high-stock-specific factors to decline, shaky balance sheets to be exposed, and so on. Consequently, one of our key messages after the first quarter of 2008 was: Expect more volatility ahead and understand your factor positioning to get a better feel for how your portfolio might react. That message applies today.
By the end of 2008, we were debating the usefulness of stress testing during the events of that year. In short, stress testing had worked pretty well in estimating future performance, but we determined that, for the moment at least, it was too new and unproven to be embedded regularly in portfolio construction. Given that stress testing had been effective in helping to frame the risks, however, we started talking about the other side: Broadly speaking, the firm’s investors had shifted to more defensive positioning over the course of the year. So was the potential for missing out on a “relief rally” the “stress” risk we should be worrying about? That warning eventually proved correct, although there were a few more down months to endure.
Where are we today?
Currently, it feels more like the end of the first quarter of 2008 than the end of 2008. With this in mind, my message to investors today is that now is the time to focus on stress testing portfolios (if they haven’t already). Importantly, it is not necessary to predict what will happen or call the way in which the market may go down. What’s more, I see no need to isolate a particular historical event that matches today’s with the same “before and after” macro, rates, and fundamental characteristics. There is no harm in simply throwing a wide range of historical, factor, and macro shocks at the portfolio to see what happens. Ultimately, the point of the exercise is to understand the key drivers in a test, what contributed to the largest outliers, and how that matches up with the investor’s current conviction.
I’d offer several other suggestions on mindset and approach:
- No model is going to be perfect. It is about understanding the distribution of potential outcomes and asking, “Can I live with these results?” When conducting a stress test, “perfection paralysis” can get in the way of having a good idea of your core risks.
- Break up recency bias. It is hard to believe now, but heading into 2008, the majority of the firm’s approaches were significantly overweight emerging markets, materials, cyclicals, and energy. Guess what? At the beginning of 2008, many risk models were also biased toward what had worked before, thus influencing results. The lesson? Use models from different regimes.
- Consider a variety of shocks. It can be helpful to review shocks like Bear Stearns/Lehman Brothers, the 1994 rate hikes, the Long-Term Capital Management crisis, and the Asian currency crisis, but others warrant consideration, including the TMT bubble, the COVID-driven market crisis, the 2011 US debt downgrade, and the Enron collapse. Factor leadership in market shocks can be very different, after all. So far, this one has been more about solvency risk factors (i.e., the probability of default) and less about high-beta factors.
- Try reverse stress testing. This is something our Fundamental Factor Team does today in our manager research. It involves throwing all factor, industry, and historical stress shocks we have in our library at the portfolio and reviewing the top and bottom results for factor drivers in order to better understand which types of events the portfolio may be most exposed to.
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