Tuesday, September 10th, 2013

Events, Dear Boy, Events

When asked by a journalist what he was most afraid of, Harold MacMillan, the former British Prime Minister, replied, “Events, dear boy, events.” It’s a view that many fund managers will sympathise with, but blaming something on Event Risk can be an excuse for not paying attention to what normal risk metrics are telling you about your portfolio. Event Risk needs to carefully defined.

Few investors could have predicted the timing of the Syrian chemical attack or its diplomatic consequences. Fewer still have the mandate and the confidence to base their investment strategy on such a prediction. One reason for this is that the investment effects are often less dramatic than the headlines. By way of example, all of Harlyn’s sector models (US, UK, Eurozone, Japan) were underweight Energy at the end of July and were therefore on the wrong side of the increase in the price of crude in August. Despite this, the negative impact on relative performance was less than 30bps over the month, and in some models there was a very small benefit.

Some commentators think that the event risk in the Syrian crisis should be measured by its impact on the split of the portfolio between equities and bonds, but we believe that worries about the Fed Taper predate the crisis and are more important anyway. The headlines are not helpful, but they are not the cause of the problem. When we drill down into our US equity / bond model we find that the structure of risk is virtually unchanged – the volatility of the S&P 500 relative to medium-dated Treasuries has not moved over the last month. Maybe it would have fallen if there had been no crisis, but we can never prove the counter-factual. The factor driving the reduced exposure to equities is relative momentum. Even though bonds have been falling, the momentum of equity returns has been falling faster. It looks to us as though investors are starting to realise that the US equity rally is mature and in need of new triggers. This is not Event Risk.

Just because something happened does not make it an Event. There are two main tests (1) Can we imagine a world in which the Event did not happen? (2) Are there immediate, measurable and material investment effects?

For example, the award of the 2020 Olympics to Tokyo passes the first test – it could have gone to Madrid or Istanbul, but it fails the second. In five years’ time, we may look back and identify this as the decisive moment when we knew that Japan was going to turn the corner, but no-one will regard it as event risk by then. It will be part of the normal landscape of risk and return. Syria also passes the first test, but fails the second because the sector effects are not material and the asset allocation effects are not measurable. The best examples are stock specific like the Vodafone / Verizon deal which clearly had an impact at the sector level. But even here there are problems; many telecom analysts will tell you that they could not imagine a world in which this deal did not happen sooner or later.

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