This article was originally published by Value Walk on December 6th, 2017
Co-authored with Daniel Wagner of Country Risk Solutions
Risk continues its inexorable march across the physical and virtual dimensions, with the diverse nature of threats now unprecedented in terms of severity, and their potential impact for lenders, traders, and investors. With the risk landscape only set to increase, a proactive approach to risk management at the macro, strategic and, increasingly, tactical level is not just a necessity to mitigate risk, but a precursor to maximising upside potential in the new year.
2017 proved to be a broadly significant year for emerging markets (EM), buoyed by bull markets in the West coupled with growing resilience. How long this impressive run will (or can) continue has become a pressing question. China’s October economic data and recent stock market declines have signalled a slowdown, raising concern that contagion could again spread as it did in 2015 and 2016. However, this shouldn’t lead to an exodus since diverging markets across middle income economies are evolving, showing more sustainability and interconnectedness, and there is growing evidence that any prolonged decline may not be as catastrophic as it has been in the past. Yet it does imply that fund managers must now accept that a ‘generic EM’ no longer exists, nor does the notion of ‘generic’ risk management.
Given the multifaceted nature of risk, effective risk management now requires a proactive approach with continual, dynamic information gathering to support discretionary investing and cross border trading. Conventional wisdom used to dictate that because everyone else is investing in a given country or company, it must be the right place to invest – the idea being that strength lay in numbers. The ‘herd’ mentality has not only caused significant losses, but placed the existence of particular funds in jeopardy (the steep decline of Petrobas in Brazil being a prime example).
While generalist investors know that certain regions are fraught with risks, and that some economies have failed to perform even close to their potential, they continue to invest long in the belief that eventually things will get better and when they do, the return will be so outsized it will vindicate their thesis. For short and activist funds seeking to profit from local market inefficiencies, some regulators are growing more hostile to foreign entities implementing short-term strategies.
We no longer have the luxury of assuming that everything will work out, nor can we maintain the mistaken belief that the horror stories that have happened to other funds will not happen to us. The question is how to implement a strategy cognisant of the true nature of risk in each particular case. Since most funds tend not to have political and non-financial risk specialists on their staff, it is incumbent on analysts to look beyond credit risk and identify the unique combination of risk factors that exist for each specific investment.
Risk management is an art, not a science, and the average risk manager will have had no formal training in the subject. Managing risk is all about creating a mosaic of factors that form a unique profile for each transaction, regardless of strategy. ‘Enhanced’ due diligence – integrating ‘deep dive’ investigations with physical and virtual methodologies – should be the new normal. Reputation risk is now an integral part of this mosaic, requiring a realistic assessment about organizational costs when things go wrong. Utilizing the services of local specialists – once considered a luxury – has become standard operating procedure in many parts of the world to uncover a range of irregularities, and when investigating ESG concerns. Situational awareness at all levels is now mandatory.
For many though, box ticking due diligence is still the preferred approach. It is not unusual for managers and analysts to not like the information they receive when undertaking a comprehensive pre-investment investigation. Knowing too much is sometimes considered more damaging than remaining ignorant, having the potential to jeopardize a deal they may, or may not, have worked hard to find. The potential repercussions of this methodology are too numerous to list here.
For all the compulsory enterprise risk modelling that is undertaken pre-investment, this does not negate the need for monitoring and oversight during the lifetime of the project. Reputation damaging controversies can arise even after thorough investigation and reactive damage limitation and crisis PR will never match preventative activity. In one case where a false bottom in an oil tanker was skimming off each consignment, reactive measures failed to recover the oil but a coordinated asset monitoring plan would have protected the resource and its returns.
Close monitoring also provides an opportunity for dynamic information acquisition to enhance the upside; early market signalling is something funds are chasing regardless of strategy. The demand for alternative or ‘Alt Data’ (seeking alpha from signals within large, largely unconstructed data sets) sources has accelerated, although in some circumstances an individual sitting in the right place can provide a similarly effective solution. Observational insight from ground level, reporting in real time, is still likely to be the fastest method of delivery on tradeable information.
Data analytics is enabling risk management to adopt a more scientific approach but this also needs to be backed up with on the ground corroboration from a variety of sources, particularly when data remains limited and noisy. Pressures and biases will always exist in the decision-making process, which can lead to an undue belief in the level of success. Only corroborated facts from the ground and, where possible, data analysis, can provide effective insight to a counter opinion. This must be channelled through short lines of communication imposed for rapid and decisive action as and when necessary.
Even post-investment risk management has taken on new meaning, for shareholders, investors, and lenders alike have come to expect that investing in EM has evolved to become transaction-driven at all levels of the investment process. Market exit has been a major thorn for funds invested there in recent years. Those who think only of the pot of gold at the end of the rainbow and fail to craft a realistic exit strategy do so at their own peril, and that of their investors.
If 2018 proves to be a year of continued growth, as we expect it will, returns are going to be squeezed as market evolution creates an increasingly competitive environment. EM fund managers will need to broaden their horizons and pursue unusual opportunities in exotic locations, but with reduced prospective margins to support any significant write downs. If growth does stall, current investments will need to be protected and opportunities evaluated much more carefully. Either way, in this new normal, non-financial risk must be methodical, holistic and on-going to protect both returns and reputation under ever more opaque circumstances.