19 October 2020
The Covid-19 pandemic took investors by surprise. With hindsight, it was a known risk that we were unprepared for. What can investors do to protect themselves from future shocks? Claire Jones recommends focusing on resilience.
When investors think about the risks they face, they often think in macro-economic terms – the risks from interest rates, inflation, exchange rates and so on. Another approach is to consider the underlying drivers of change in these variables – for example, geopolitical tensions, migration, automation, climate change and pandemics. These are often market-wide or systemic, ie risks that can affect large parts of the economy at the same time. By definition, investors cannot escape them by judicious choices of investment. So what can they do to protect themselves?
A key word here is resilience. In other words, the capacity to recover quickly from difficulties. It doesn’t necessarily mean reverting to the status quo; it can mean adapting to the new normal and pursuing the opportunities it brings. It requires nimbleness and flexibility.
Investors can consider resilience at multiple levels.
It isn’t possible for companies to prepare for every eventuality and it would be inefficient for them to try. But there are ways in which they can build resilience to help cope with whatever difficulties they may face in future. For example, ensuring operational and financial flexibility, diversifying their supply chain, envisioning different futures when developing their long-term strategy, challenging group-think and being open to change.
Through their engagement with companies, investors can encourage these practices and make it clear that they want companies to deliver strong long-term performance rather than (just) short-term results.
Whilst none of us have a crystal ball, it is easy to identify themes that could be the cause of future investment shocks – for example, climate change, loss of biodiversity, water scarcity, inequality, unemployment, antimicrobial resistance, artificial intelligence and cyber security. The World Economic Forum’s annual Global Risks Report is one good source of ideas (even though the ranking of risks inevitably reflects what was top of mind when participants completed the survey – no doubt infectious diseases will feature much more highly next time!).
Once key themes of concern have been identified, metrics can be developed that enable the extent of investments’ exposure to these risks to be monitored. This is easier said than done, given the large number of potential themes, many of which are complex and hard to quantify. It will therefore be necessary to prioritise themes and to seek a small number of metrics for each one that provide useful insights into exposures. This will help investors to identify problem areas and any changes over time that could be a cause for concern.
Portfolio and investor level
As well as considering the exposure of individual investments to these risks as part of investment due diligence, investors should monitor their aggregate exposure to ensure they do not have unintended concentrations of risk. This should be done at both the mandate and the investor level. We are starting to see this being done for climate change, where the Taskforce on Climate-related Financial Disclosures and others are encouraging the use of metrics that can be aggregated across mandates.
Their investments may not be the only source of investors’ exposure to these themes. For example, a pension scheme may be exposed through its sponsor covenant (i.e. systemic shocks could impact the employer’s ability to pay future contributions) while a charity may be exposed through its operations (eg the shocks could affect donation income or demand for its services). Ideally all sources of risk exposure (i.e. both investment and non-investment) will be considered in an integrated manner.
Scenario analysis can be a useful tool here, exploring how different possible futures may unfold, how the investor may be affected and what actions could be taken to mitigate the risk. Such analysis is not about forecasting the future – it’s primarily about building understanding and informing decision-making. It is fast becoming a widely used tool for climate-related risk management, prompted by its endorsement by the Taskforce on Climate-related Financial Disclosures. Many organisations are working to develop, trial and improve methodologies.
Investors should also seek to improve resilience within their own organisation. The characteristics outlined above for investee companies may be relevant here, both for the investor’s decision-making body (eg board of trustees or investment committee) and for the source of its income (eg sponsoring employer or charitable activities).
Given the very nature of systemic risks, there are limits to the actions that can be taken at investment and investor level. Quite often, resilience needs to be built at a larger scale. The pandemic provides a case in point – many of the shortcomings that have been exposed relate to lack of government preparedness. If investors had identified pandemics as a key concern, then – rather than raising this in their discussions with individual companies – they arguably should have been pushing governments to implement expert recommendations (such as those from the Global Preparedness Monitoring Board) and to ensure healthcare systems were properly funded. Governments can’t prepare for every eventuality – and shouldn’t try – but they should have appropriate contingency plans in place for the most-likely high-impact risks and implement measures that increase general resilience.
As awareness of the importance of systemic risks grows, we are seeing investors devote more time to so-called policy advocacy, but there is scope to do more. Policymakers are influenced by what they think investors and businesses want, and it is important that this is not based on false assumptions such as the primacy of short-term economic performance. Increasingly there is recognition among the investor community that looking after the health of our social and environmental systems is vital for longer-term economic performance. As governments seek to navigate their way out of the current crisis, there is a unique opportunity to build back better and hence address some of the future sources of investment risk, notably climate change and inequality. In addition, the need for global co-operation has never been more apparent – and is particularly important for investors due to their global exposure – and yet this is faltering. Investors should ensure their voices are heard on these topics.
Your role as an investor
It is tempting for investors to think that systemic problems are too big to influence and just leave them for others to solve. But who are those others? In our fragmented financial system, if we all leave it to others, nothing will change. Instead, we all need to act. The UK Stewardship Code 2020 recognises this in its Principle 4 which requires signatories to “identify and respond to market-wide and systemic risks to promote a well-functioning financial system”.
So do think about your role in relation to systemic risks. You probably delegate the day-to-day management of your investments to asset managers, but you retain overall responsibility and so need to oversee what they are doing. Include stewardship in your manager selection and monitoring, asking explicitly about their approach to systemic risks and communicating your expectations in this area. Don’t take their answers at face value, but dig deeper to ensure they are taking the topic seriously and allocating the resources it deserves. Use your influence to drive better practices across the investment chain. Identify themes of particular concern, develop a holistic approach for assessing and monitoring your exposure to them, and seek ways of building your resilience to future investment shocks – whatever their source.