The changing nature of geopolitical risks has made them harder to manage, even though the adversaries to an American-led world order have remained nearly the same over the decades, according to Stephen Kotkin, the Kleinheinz Senior Fellow at the Hoover Institution.

These risks can still be managed between the extremes of appeasement and provocation, and will require allies and friends to work with US, as well as fiscal power to undergird the challenge, the Top1000funds.com Fiduciary Investors Symposium at Stanford University heard.

“The world has changed a lot less than it seems,” Prof Kotkin, who is a specialist on geopolitical risk and authoritarianism, said. “So it’s manageable, it can be done; and if it’s not managed, then it’s unpriceable geopolitical risk.”

The geopolitical world, and America’s adversaries, are largely the same as in 1945 when the US-led order was created. It’s no longer Russia as the senior partner in the Eurasian bloc that’s opposed to US power now, instead it is China. On the other hand, Iran, which was part of the US-led order before the Islamic revolution in 1979, has now flipped.

Kotkin said the US bloc has remained vulnerable to conflict since 1945, in three places across the world – Crimea, Israel and the South China Sea.

At the time, the Soviet bloc formed “borders of victory” after winning World War II and taking over Eastern Europe, and a chunk of the Korean Peninsula. By contrast, the current conflicts centre around “borders of defeat”.

“They used to have it, they don’t have it, they want it back,” he said, referring to territorial conflicts in Ukraine and the South China Sea.

“It’s a lot harder to stabilise the other side when it wants the land back, unlike the Soviet case, where they had what they were after.”

Another key difference is that everything that happens everywhere is now potentially interconnected. While it took the world a while to master radio and TV technology, the power of the internet has been much harder to control.

“This interconnectivity, which is so empowering, is also massively destabilising, and we don’t know how to manage it. It’s relatively new,” Kotkin said.

Another key contrast to the old state of world affairs is the growing problem of “dual-use” technology, he added.

Back in the Soviet days, technology could either be classified as of use to the military industrial complex, or for consumer goods.

“Now, the rocket and the refrigerator, it’s the same. It’s all just a bunch of semiconductors and other dual-use technology,” Kotkin said, giving the example of a small private company that may simply come up with an innovation in computerisation, but which could be potentially considered as having military industrial applications.

These are the major differences in the world we live in now compared to 30 to 40 years ago. Otherwise, it’s the same problematic with the US led world order, like it or not, he said.

“In real life, it’s not justice and equality and sovereignty. It’s a US-led order with warts and all, or it’s the other guy’s order, and so solving that problem is really hard with these three big changes that have happened.”

Investment heads at large global funds are reorganising their portfolios as they look to future-proof against global macro risks on the horizon and take advantage of potential opportunities.

Changes in strategies include cutting down on risk, higher allocations to equities and a shift to focusing on absolute returns, the Fiduciary Investors Symposium at Stanford University has heard.

James Davis, chief investment officer at the $25 billion Canadian pension fund OPTrust, says while asset owners are pretty good at managing short-term bouts of volatility, his bigger concern is a period of sustained inflation over the longer term.

“If we have a period where government finances are more problematic, and we know historically, one of the ways you deal with that is for governments to inflate their way out,” he said.

“What is that going to do to asset values over the long term, especially if there’s no real inflation protection built into them. And how is that actually going to impact an overall pension plan.”

Davis said his fear stems from the fact that his pension plans liabilities are fully indexed to inflation, so a scenario where asset values drop but liabilities rise would be “like the worst case”.

Another long term worry is about potential changes in regulatory policy setup that would require financial institutions like pension funds to bear unnecessary inflation risk because they are forced to own long term bonds.

Portfolio Risks

Jay Willoughby, chief investment officer at TIFF Investment Management, says while his fund follows an endowment model and an active management approach, his concerns regarding risks are similar.

One of the issues is on the fiscal side, he said, with a $35 trillion US budget deficit, a $27 trillion off balance sheet liability to the Social Security fund, and a $42 trillion off balance sheet liability to the Medicare Trust fund. Western countries have also used their control of the SWIFT banking system and frozen assets from the east.

“I don’t know what’s going to happen with the value of currencies. That’s one thing that hasn’t been talked about from an investment standpoint. But there’s a number of places in the world that are trying to use fewer dollars in their transactions and trades,” he said.

If artificial intelligence can increase productivity, the US might be able to bail out long-term bond holders and keep inflation down. But that would also result in a significant amount of opportunity in the stock market.

“So my best guess is that that it’s going to be harder to make money,” he said. “Maybe there’s not so much opportunity in bonds. We don’t see any fat pitches in to try to take advantage of and we’re a little late on the bond side.”

Alison Romano, the CEO and chief investment officer of the San Francisco Employees’ Retirement System (SFERS) says her team was extraordinarily successful taking active risk to reach its 7.2% return target and it worked for a long time, until the market shifted.

“So we’re changing. We’re not clamping down on risk, but we’re making sure that where we choose risk that aligns with our skill set,” she said.

That will mean increasing allocation to fixed income, given that the fund has reached a 97% funded status and has the opportunity to not chase returns.

“It’s really making sure that we know why we’re doing what we’re doing, and that the components of the return together will diversify and have each component acting as we’d expect, because I can’t predict what what’s going to happen,” she said.

Absolute Return Focus

With portfolio construction being harder under the current circumstances, the CIOs see advantages in shifting to a focus on absolute returns, rather than simply seeking to outperform benchmarks.

“We’re moving in that direction increasingly. So we’ve got in our portfolio, it’s basically divided into two large components. There’s the illiquid assets, and there’s liquid assets,” OPTrust’s Davis said.

He says historically, he would have used something more akin to a traditional SAA type framework to decide what that liquid mix should be, and then allocate to teams to generate alpha.

“Not sure that’s as effective as it could be. It’s certainly not consistent with our total portfolio approach. And what we find is the teams tend to focus more on alpha than they do on actually generating the best returns for the fund.”

TIFF, meanwhile, is turning to a hedge fund approach to generate portfolio gains regardless of market conditions. It is also betting on a higher allocation to equities.

“In the future, whatever your asset allocation is, push yourself to think about owning more stocks and fewer bonds. If currencies are going to become more important, you might own those stocks overseas,” Willoughby said.

While SPERS has a 10 per cent allocation to absolute return, Romano says the fund will continue to evolve asset allocation, as the markets evolve. That includes looking at how to utilise leverage better, and bringing in more analytics into the decision making.

“We talk a lot about markets, but it is a people business, and so there’s a lot of change management and working with the team and making sure that as we shift that there’s buy in,” Romano says.

“So, it’s both, responding to the markets, but also making sure we have a system where we have really good idea generation.”

Nobel Prize-winning economist Myron Scholes says changing how investors look at risk can improve the way it is managed, and can help boost returns.

He told the Fiduciary Investors Symposium at Stanford University that the focus of asset owners needs to shift from thinking of risk as a constant to considering how risks are changing. Then, the two important things in investment that would have to be included are time and risks changing.

“Most of what we’ve done in the past is concentrate on cash flows and trying to estimate cash flows. In my view, we also have to think about how discount rates change,” Scholes said.

“How the discount rates change affects our portfolios, and risk is really discount rates and thinking about how they change over time.”

The discount rate is low during times when risks are low, and when when risks are high, the discount rate is high.  So the important part is really the phase transition, or how we get from low to high and high to low.

“It’s really trying to understand how to get information when risks are changing, not just the level of risk. And then if we concentrate on risks changing, we can then increase our return,” Scholes said.

For example, if asset owners know that risks are going to increase in the future, they would want to reduce their risk and have more powder dry, than when risk goes the other way. So they can reallocate.

“Even if you’re in a long run horizon, phase transitions are very important in risk. And what the data shows is that’s what we should be looking at. Not necessarily the level of risk today, but how it is changing. How to get information about changing risk to enhance our rates of return.”

Time Value

Scholes says asset owners typically think of risk management in four different ways.

One is the idea of holding inventory, so deciding on what risk to hold. That could be in the form of either a strategic allocation, or even tactical tilts such as more equities, less bonds and vice versa. Another way is turning over inventory to make money or generating alpha, whether through short term plays or by thinking about themes. But that is quite difficult.

The third way is to look at what the constraints of others are, and when they’re willing to transfer risk and pay people to take their risks, or periods such as liquidity crises when people want to liquidate portfolios quickly and dramatically.

“Because the risk changed, the price changed, the risk premium changed, the required rates of return changed, and you can make money by stepping in,” he says.

The fourth way to manage risk is to smooth the discount rate over forward in time, such as when you’re a long horizon equity holder, have no interim cash flows to worry about, and can hold for a very long time. Basically, a buy and hold strategy, or the strategy behind passive investments.

“The problem with that is it doesn’t take account of time. And the interesting thing in time is that even though it averages out, the volatility hurts you because compound return is what we should be interested in,” Scholes said.

Risk has multiple dimensions that we have to consider, so every period counts, and that is an advantage, because in compound return, everything multiplies.

“As every period matters, then we have to think about how to get information, not about what’s going to happen five years or three years from now, what’s going to happen next quarter or the quarter after that, if we’re managing money.”

The increasing willingness on the part of regulators such as the Federal Reserve to bail out investors at times of crises is reducing the competitive environment in which banks and financial institutions operate, the Fiduciary investors Symposium at Stanford University has heard.

Ross Levine, the Booth Derbas Family/Edward Lazear Senior Fellow at the Hoover Institution, said the Fed’s practice of insuring the liability holders of financial institutions was encouraging more risky behaviour and creating a fragile system in the longer run.

“This means those financial institutions are likely to take excessive risk, because the people with the money on the line don’t have their money on the line, because the government will bail them out.”

“Without those entities providing governance over the financial institutions, the degree to which they are going to allocate capital effectively to the people with the best entrepreneurial ideas is diminished,” he added.

Levine, who is also a research associate at the US National Bureau of Economic Research, has previously criticised the Fed’s perceived lack of regulatory power through the global financial crisis and other banking crisis in the US. He has also criticised the high incentives of financial services executives.

The question I always asks regulators when a major bank fails in the US: what decision maker at that institution loses their house? And the answer is either silence or murders of ‘nobody’, he said.

“If you have a financial system in which the decision makers don’t share in the downside, this simply cannot be sustained for the long run, and so that incentive is what scares me.”

He says the Fed has essentially insured all liability holders in financial institutions, except for shareholders, even though by regulation, a large bank in the US cannot have a shareholder that controls more than 5% of the equity.

That means all liability holders who are supposed to provide governance are insured, so the only entity that can really be in a position to monitor excessive risk taking, are the regulators.

“I think the Fed is caught within the context of a political and social expectations in the US. We don’t interfere with free markets, but at the same time, we don’t want people to lose money, so we’re going to provide this insurance for liability holders,” Levine said.

“You can’t have both of those. You can’t have insurance of the liability holders, which encourages excessive risk taking, without the regulation that constrains the excessive risk taking, and philosophically, the US doesn’t seem to be able to resolve this.”

Reliable Indicator

Levine says his research has shown that the financial sector has been fundamentally important for promoting economic prosperity across the US states and across the world more generally.

It is also one of the most reliable indicators about how an economy is going to perform in the long run.

“How an economy’s financial sector is performing, how open it is for competition, is its regulatory system one that promotes competition?. These sets of analysis are a very useful way to understand and predict which countries are going to succeed.”

Responding to a question about using growth as an accurate measure for the health of an economy, Levine said that GDP growth, over long decades, is a pretty good summary statistic for how the economy is doing. It’s not perfect, but there are no good alternatives.

That is because GDP growth, if measured correctly, is not just about more stuff but also about better stuff.  “I’m thinking about that as a proxy for a better standard of living on average, not just, you know, more TVs per capita.”

Levine criticised both major political parties in the US for moving away from a focus on growth, and considering the economy as a zero sum game. That has meant people are worried about the relative slice that they’re getting, and less about increasing the size of the economic pie.

The reduced focus on growth feeds into the fact that the US is in the midst of a major fiscal crisis, with the overall debt to GDP ratio somewhere between four and five times as great as it was after World War II.

“That’s a gigantic problem and and very difficult decisions are going to have to be made. Those decisions are going to be easier and less severe if the economy is growing,” he said.

The transition to net zero is well underway, but it won’t be a smooth path and getting there will pose significant risks for investors. These are the conclusions of a new report by Pictet Asset Management and the Institute of International Finance. It will require higher levels of borrowing by the companies they invest in; the risk of transition-related “greenflation”, along with increases in unemployment; and the possibility of creating asset-price bubbles as a vast amount of capital chases a relatively constrained supply of assets.

To avoid these pitfalls and others, investors must take a measured approach to assessing opportunities as they arise, including assessing the extent to which markets have already priced-in the “greenness” of companies, and what implications that has for alpha generation. And that requires deep research and confidence in available data – which in some cases continues to be patchy.

Pictet Asset Management senior investment manager Yuko Takano, managing investment director, sustainable investments at CalPERS Peter Cashion and Institute of International Finance director Emre Tiftik discuss the opportunities and risks investors need to understand to maximise returns as the energy transition progresses.

In conversation with Top1000funds.com editor Amanda White, they discuss how it’s possible to generate outperformance by investing in climate solutions; and how investors should think about the associated risk and alpha opportunities.