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As stewards of investors’ capital, asset managers must walk a fine line to achieve attractive returns while also ensuring reasonable risk management. With the market moving to a more uncertain economic environment, investors are prudent to look into how asset managers are upholding their fiduciary duties.
Many signs point to an imminent turn in the U.S. credit cycle after almost a decade-long run. Assets ranging from leveraged loans to corporate bonds are approaching the contraction stage of the cycle, according to asset management company AllianceBernstein. Meanwhile, years of low borrowing costs have helped raise property prices and propel equities to new peaks over the past decade.
But the factors that gave the bull market so much steam are dying down.
The result, I believe, is that many professional money managers must now cope with a litany of potential portfolio risks, such as higher interest rates, elevated market volatility and reduced credit availability. As the founder and CEO of M360 Advisors, I have been responsible for managing asset allocation of the funds my company handles. And I believe amid solid, but wavering, economic indicators and increased speculation of further market corrections, it’s more important than ever to be a conscientious manager of investment risk. So, what does that mean?
Rules one, two and three: Don’t lose money.
In my experience, smart risk management starts with a commitment to capital preservation, where the baseline goal is to minimize potential losses. Taking into consideration where the markets sit today, I believe that might mean it’s time to book profits in equity investments and rebalance more toward fixed income assets.
Many asset managers have enjoyed the upward trajectory of the S&P 500 and the Dow Jones Industrial Average since 2009, with equity investments helping to propel returns into the double digits. But equities are volatile, and they carry the potential to sink an investment portfolio. Managers who proactively shift into debt can explore higher-rated, floating-rate securities, which typically perform well against comparable credits in rising-rate markets. Even in these securities, asset managers should consider opportunities that are secured by real assets, such as property, in first-lien positions at the top of the capital structure.
Lenders writing loans should also take a forward-thinking approach to risk management. I believe the lenders who tend to perform best in times of market stress are those who only underwrite loans where they would be willing to own the underlying asset, or where they have other options to protect their capital if everything goes wrong.
For example, in the commercial real estate market, failing tenant businesses are one of the most common issues. In this situation, a borrower may default, which leaves the lender in trouble unless they are willing to own the property at the rates underwritten in the loan. As a veteran of the commercial real estate market with more than three decades of experience, I know that it helps to have the land and building collateral backing the investment and preserving base case capital.
Following the masses could lead to a cliff.
Being perceptive about market risk means monitoring the masses and avoiding following them. Even professional money managers make the fundamental mistake of using an asset’s or sector’s past performance as an indicator for future gains or losses. We also often see emotionally driven investing; this is exemplified by the market volatility caused by investors’ excitement to rush into the next Google or Bitcoin, or their fear to exit positions as a correction depletes their returns. These investors often enter markets late in a cycle after having missed the lion’s share of asset appreciation. I believe being perceptive about risk means adopting a more strategic investment outlook that encompasses the overall market — not one that tries to time the market.
In my experience, investors should also avoid the hazards inherent in taking on risk to reap last-minute rewards as the end of the bull market draws closer. Some asset managers have gotten comfortable in the environment of lower interest rates, increased leverage, weaker loan covenants and rising asset prices. Being a conscientious manager of investment risk means adopting a proactive, yet defensive, approach to changing market conditions to preserve gains and lighten up on highly leveraged or more speculative positions that expose large portions of capital to shocks.
Evaluate factors that extend beyond your market.
Asset managers should be alert to risks that come from outside of markets as well. There may be offsetting forces gathering that could upset assumptions and aggravate uncertainty. For example, signals from the robust U.S. economy could be misleading. Even as the U.S. continues to post strong economic numbers, deceleration in Europe and China could weigh on growth.
What’s more, few know how long tax-cut gains will continue to buoy U.S. corporations or how drastically tariffs could slow global growth. Conscientious managers of risk should take note that other factors could present problems over the near horizon. U.S. corporations, for example, have been borrowing at higher levels than they were before the financial crisis, according to S&P Global. Leveraged loan and corporate debt numbers have reached records, which I believe signals that many companies could be getting stretched thin. Considerations such as these could delay the Federal Reserve’s plans for adjusting interest-rate targets or fuel further stock market declines, which could eventually spill over into other markets.
I believe asset managers charged with steering investor capital toward stable gains must consider the myriad effects that tariffs, wobbly earnings and uncertain global growth could have on credit markets and interest rate expectations. As indicators suggest the credit cycle approaches a tipping point, responsible risk managers should adopt measures to minimize losses and still generate positive returns.