understanding risk and its effective management romeo makhubela ceo

Understanding risk and its effective management

Romeo Makhubela

CEO

• Introduction – what is risk?

• 3 big picture concepts

– Time

– Fund dynamics

– Regime switching.

• Conclusion

• Introduction – what is risk?

• 3 big picture concepts

– Time

– Fund dynamics

– Regime switching.

• Conclusion

Agenda

Institute of Risk Management considers

• Uncertainty (travel arrangements)

• Danger (skydiving)

• Probability (SA to win Rugby World Cup 2011)

• Variability (buying a lotto ticket)

• Dread (shark attack).

Peter Bernstein in his book “Against the Gods: the Remarkable Story of Risk” demonstrates a perspective that requires one to

• “define what may happen in the future and choose among alternatives”.

• he states that risk should not be feared, and goes hand in hand with challenge and opportunity.

Institute of Risk Management considers

• Uncertainty (travel arrangements)

• Danger (skydiving)

• Probability (SA to win Rugby World Cup 2011)

• Variability (buying a lotto ticket)

• Dread (shark attack).

Peter Bernstein in his book “Against the Gods: the Remarkable Story of Risk” demonstrates a perspective that requires one to

• “define what may happen in the future and choose among alternatives”.

• he states that risk should not be feared, and goes hand in hand with challenge and opportunity.

Its all about perspective

What is risk?

The quantifiable likelihood of loss or less-than-expected returns due to

Currency- Interest Rate-

Inflation- Equity-

Principal- Credit-

Country- Unsystematic-

Economic- Call-

Mortgage- Business-

Liquidity- Counterparty-

Prepayment- Purchasing power-

Opportunity- Event-

Income-

……….RISK

The quantifiable likelihood of loss or less-than-expected returns due to

Currency- Interest Rate-

Inflation- Equity-

Principal- Credit-

Country- Unsystematic-

Economic- Call-

Mortgage- Business-

Liquidity- Counterparty-

Prepayment- Purchasing power-

Opportunity- Event-

Income-

……….RISK

Investor Words definition

What is investment risk?

What factors are in play that can derail the expected outcome?

• Risk is the future uncertainty of a current decision.

• To be make money, we need to be exposed to it.

• How much we can tolerate depends on

– how financially wealthy we are,

– what we are trying to achieve, and

– how much time we have to wait.

• It is the amount of exposure to risk, of the right kind, that determines success or

not; but:

• Risk is NOT independent of expected return.

• Risk is the future uncertainty of a current decision.

• To be make money, we need to be exposed to it.

• How much we can tolerate depends on

– how financially wealthy we are,

– what we are trying to achieve, and

– how much time we have to wait.

• It is the amount of exposure to risk, of the right kind, that determines success or

not; but:

• Risk is NOT independent of expected return.

Some commentary

• Time

– As a general rule of thumb, the longer the time to one’s target date, the

more aggressively one can invest.

• Fund dynamics

– one “solution” does not fit all; requires migration through complementary

solutions

– risk management solutions can no longer be static.

• Prevailing environment (Regime switching)

– within this dynamic solution, one must respond to differing market

environments.

• Time

– As a general rule of thumb, the longer the time to one’s target date, the

more aggressively one can invest.

• Fund dynamics

– one “solution” does not fit all; requires migration through complementary

solutions

– risk management solutions can no longer be static.

• Prevailing environment (Regime switching)

– within this dynamic solution, one must respond to differing market

environments.

3 big picture concepts that impact ability to assume risk

Risk acceptance

00 01 02 03 04 05 06 07 08 09

1900 15% 18% 4% -7% 22% -20% 15% -11% 41% 30%

1910 -14% -15% 7% -6% -12% 7% 12% -3% 6% 33%

1920 -43% 2% 76% 10% 17% 16% 25% 8% 2% -2%

1930 -7% -6% 34% 113% 33% 17% 28% -20% 1% -7%

1940 0% 16% -3% 19% 8% 22% -4% -13% -9% 25%

1950 -10% -1% -8% 0% 18% -7% -6% -4% 19% 32%

1960 -2% 10% 27% 22% 15% 4% 16% 18% 48% -14%

1970 -30% 2% 52% -4% 1% -22% -12% 18% 23% 70%

1980 21% -12% 22% 3% -3% 20% 33% -17% 2% 35%

1990 -17% 13% -11% 41% 12% 2% 0% -10% -16% 51%

2000 -7% 21% -17% 11% 20% 41% 34% 10% -32% 22%

2010 14%

over the short term

Time: Equity returns are uncertain...

data

: an

nual

tot

al r

etur

n an

d in

flatio

n da

ta f

rom

190

0 to

201

1

data source: Prof C Firer annual data 1900 – 2008

00 01 02 03 04 05 06 07 08 09

1900 9%

1910 6% 3% 3% 3% 0% 3% 2% 3% 0% 1%

1920 -3% -2% 3% 5% 8% 9% 10% 11% 11% 8%

1930 13% 12% 9% 17% 18% 18% 18% 15% 15% 14%

1940 15% 17% 14% 7% 5% 5% 2% 3% 2% 5%

1950 4% 2% 2% 0% 1% -2% -2% -1% 2% 3%

1960 3% 4% 8% 10% 10% 11% 13% 16% 18% 13%

1970 9% 9% 11% 8% 7% 4% 1% 1% -1% 6%

1980 12% 10% 8% 9% 8% 13% 18% 14% 11% 9%

1990 5% 7% 4% 8% 9% 7% 4% 5% 3% 4%

2000 6% 6% 5% 3% 4% 7% 10% 12% 11% 8%

2010 11%

Equity returns...

data

: an

nual

tot

al r

etur

n an

d in

flatio

n da

ta f

rom

190

0 to

201

1

data source: Prof C Firer annual data 1900 – 2008

exceed inflation over almost all periods of 10 years or longer

00 01 02 03 04 05 06 07 08 09

1900 16% -6% 0% 10% 11% 9% 12% 4% 8% -1%

1910 -11% 1% 0% 1% 3% -15% -7% -5% 2% -7%

1920 -20% 25% 28% 6% 4% 6% 7% 5% 6% 5%

1930 6% 9% 3% 35% 8% 9% 3% -4% -1% 0%

1940 2% 4% -3% -1% -1% 2% 6% -3% -9% -3%

1950 -5% -9% -10% 4% 4% -3% 1% 1% -4% 5%

1960 2% -2% 20% 3% -2% -10% -4% 5% 4% 3%

1970 -11% -6% 5% 0% -17% -6% -8% 3% 9% -1%

1980 -19% -10% 16% -13% -10% -6% 15% 0% -4% 6%

1990 1% -2% 17% 21% -17% 22% -3% 22% -4% 27%

2000 12% 14% 4% 18% 10% 8% 0% -4% 7% -7%

2010 11%

data source: Prof C Firer annual data 1900 – 2008

Bond market returns

data

: an

nual

tot

al r

etur

n an

d in

flatio

n da

ta f

rom

190

0 to

201

1

data source: Prof C Firer annual data 1900 – 2008

are driven by inflation

00 01 02 03 04 05 06 07 08 09

1900 6%

1910 3% 4% 4% 3% 2% 0% -2% -3% -3% -4%

1920 -5% -3% 0% 0% 0% 2% 4% 5% 5% 6%

1930 9% 8% 6% 8% 9% 9% 9% 8% 7% 6%

1940 6% 5% 5% 2% 1% 0% 0% 0% 0% -1%

1950 -1% -3% -3% -3% -3% -3% -3% -3% -2% -2%

1960 -1% -1% 2% 2% 2% 1% 0% 1% 2% 2%

1970 0% 0% -1% -2% -3% -3% -3% -4% -3% -3%

1980 -4% -5% -4% -5% -5% -5% -2% -3% -4% -3%

1990 -1% 0% 0% 3% 2% 5% 3% 5% 6% 7%

2000 8% 9% 8% 8% 11% 9% 10% 7% 8% 5%

2010 5%

Bond market returns

data

: an

nual

tot

al r

etur

n an

d in

flatio

n da

ta f

rom

190

0 to

201

1

data source: Prof C Firer annual data 1900 – 2008

stay negative in real terms for long periods as inflation rises

00 01 02 03 04 05 06 07 08 09

1900 0% -5% 1% 13% 9% 10% 11% 5% 4% -3%

1910 -11% -1% 1% 2% 2% -1% 0% -4% -3% -6%

1920 -14% 16% 23% 6% 2% 3% 5% 2% 3% 3%

1930 6% 6% 9% 4% -1% 1% 0% -2% -3% -1%

1940 -4% -6% -8% -5% -4% -1% -2% -4% -6% -3%

1950 -6% -7% -5% 1% -2% 0% 1% 0% 0% 0%

1960 2% 3% 2% 1% -1% 2% 1% 4% 3% 2%

1970 2% 1% 0% -4% -3% -2% 1% -1% -2% -7%

1980 -9% -1% 4% 4% 7% 3% -5% -4% 1% 3%

1990 5% 2% 6% 3% 1% 7% 6% 11% 10% 8%

2000 3% 4% 1% 8% 4% 3% 3% 1% 1% 3%

2010 3%

Cash returns

data

: an

nual

tot

al r

etur

n an

d in

flatio

n da

ta f

rom

190

0 to

201

1

data source: Prof C Firer annual data 1900 – 2008

are not the perfect hedge against inflation (even before tax)

00 01 02 03 04 05 06 07 08 09

1900 4%

1910 3% 4% 4% 3% 2% 1% 0% -1% -2% -2%

1920 -3% -1% 1% 1% 1% 2% 2% 3% 4% 5%

1930 7% 6% 5% 4% 4% 4% 3% 3% 2% 2%

1940 1% -1% -2% -3% -3% -3% -4% -4% -4% -4%

1950 -4% -5% -4% -4% -4% -3% -3% -3% -2% -2%

1960 -1% 0% 1% 1% 1% 1% 1% 1% 2% 2%

1970 2% 2% 1% 1% 1% 0% 0% 0% -1% -2%

1980 -3% -3% -2% -2% -1% 0% -1% -1% -1% 0%

1990 2% 2% 2% 2% 1% 2% 3% 5% 6% 6%

2000 6% 6% 5% 6% 6% 6% 5% 4% 4% 3%

2010 3%

Cash returns

data

: an

nual

tot

al r

etur

n an

d in

flatio

n da

ta f

rom

190

0 to

201

1

data source: Prof C Firer annual data 1900 – 2008

over the short or long term

ris

k

investment horizon - years

equities

bonds

cash

absolute low risk moderate risk equity oriented growth

Asset class risk vs time

Equities deliver higher returns but with exponentially higher risk over the short term

• Risk management solutions can no longer be static.

• Consider a closed pension fund with members with characteristics differing by– age– retirement date– gender– contribution value– tax rate– accumulated benefits.

• The solution for the retirement fund as a whole is driven by the aggregate cash flows, which include contributions (by active members) and withdrawals by retired members.

• This solution is not simply 100% allocation to one fund, to and from which contributions and withdrawals are made.

• Risk management solutions can no longer be static.

• Consider a closed pension fund with members with characteristics differing by– age– retirement date– gender– contribution value– tax rate– accumulated benefits.

• The solution for the retirement fund as a whole is driven by the aggregate cash flows, which include contributions (by active members) and withdrawals by retired members.

• This solution is not simply 100% allocation to one fund, to and from which contributions and withdrawals are made.

Fund dynamics

Dynamic solution superior

Economic cycles, a starting point

Regime switchingn

orm

al

need to be viewed in three distinct states

Economic cycles

to the long term SAA to reflect the dynamics of each macro environment

Temporal adjustment

Equity Bond Cash

Con 13 27 60

Mod26 19 55

Agg 35 15 50

Equity Bond Cash

Con 29 29 42

Mod50 25 25

Agg 65 15 20

Equity Bond Cash

Con 40 32 28

Mod64 27 9

Agg 75 20 5

value add

Combining time, dynamics & environment

Statistic Balanced (Static)

Balanced (Risk mitigating)

Balanced (Opportunity

seeking)

Balanced (Regime

switching)

Annual Return 16.2% 13.3% 17.0% 17.9%

Annual stdDev 10.8% 6.2% 13.2% 10.5%

Sharpe ratio 0.7 0.7 0.6 0.8

Maximum Drawdown -19.3% -8.1% -25.7% -13.4%

• Risk is the future uncertain outcome of a current decision.

• Especially in the new millennium, three important facets to recall and consider are time, fund dynamics and regime switching.

• Time in the markets is a management tool.

• Static solutions: no more.

• Regime switching, as a critical component of the dynamic solution.

• Risk is the future uncertain outcome of a current decision.

• Especially in the new millennium, three important facets to recall and consider are time, fund dynamics and regime switching.

• Time in the markets is a management tool.

• Static solutions: no more.

• Regime switching, as a critical component of the dynamic solution.

Conclusion

Questions?

Regulatory information

Vunani Fund Managers (Pty) Ltd Physical Address:6th Floor, Letterstedt HouseNewlands on MainNewlands7700 Telephone number: 021 670 4900Internet website: www.vunanifm.co.za Vunani Fund Managers (Pty) Ltd is an authorised financial services provider (license no. 608) approved by the Registrar of Financial Services Providers (www.fsb.co.za) to provide intermediary services and advice in terms of the Financial Advisors and Intermediary services Act 37 of 2002.  Market fluctuations and changes in rates of exchange or taxation may have an effect on the value, price or income of investments. Since the performance of financial markets fluctuates, an investor may not get back the full amount invested. Past performance is not necessarily a guide to future investment performance. All returns are in rand terms, unless otherwise stated. Investment deals done on behalf of clients by Vunani Fund Managers are all done on an arm’s length basis.

Vunani Fund Managers (Pty) Ltd has been GIPS verified for the periods 1 January 2005 to 31 December 2010. A copy of the verification report is available on request.