Peter Ellsworth: There is no place to hide in a systemic financial crisis

The latest response to the issues raised by The Investment Integration Project.

Have your say: comment on this response and the original article: ‘It’s time for investors to start reporting on both portfolio and systems-level performance at RI’s Linked-in site.

Systemic risk is hardly new. Sometimes it appears with surprisingly little warning: the 1987 market crash exacerbated by “portfolio insurance” meant to insulate institutional investors, the 1994 Mexican peso devaluation and the 1998 Russian ruble crisis. Each prompted a flight to quality, with repercussions throughout global financial markets.

The 2008 global financial crisis was more far reaching, threatening or entirely destroying the solvency of well-respected financial organizations – and confounding most strategies constructed to provide diversification of risk.

We are now entering a new era of systemic risk from long-term mega-trends, especially climate risk, that will allow investors no shelter. A rapidly growing population will demand more energy and resources, stress water availability and pressure supply chains. And greenhouse gas emissions, which are already contributing to climate warming and more volatile extreme weather events causing billions of dollars of economic losses, will further impact businesses and investors. The ability of companies to mitigate and adapt to the most material of these risks will bear directly on financial performance, share price and portfolio returns, as well as the fiduciary duty and self-interest of portfolio managers.

Pension fund and endowment trustees should be able to explain how long-term mega-trends such as population growth and climate change pose risk to their portfolios – and to the larger social and financial fabric their investment returns are dependent upon. The nine billion people projected by 2050 will demand more energy, water, food, housing, sanitation, and a better standard of living – stressing energy sources, clean affordable water, and food supplies, not to mention the challenges of rising sea levels.

At the day-to-day level of investment decision-making, failure to understand how investments may contribute to these systemic risks – and be impacted by them – suggests a “world is flat” approach to risk-adjusted returns, paying insufficient attention to material risks, even though they are just beyond the horizon.

There is no place to hide in a systemic financial crisis. The prevalence of index investing by pension funds and the major institutional investors virtually assures that both active and passive strategies will be caught in the downdraft.This is part of the challenge addressed by The Investment Integration Project (TIIP) – an individual portfolio manager or an entire fund cannot safeguard against systemic risk unless most others are also doing so.

How do we encourage the consideration of systemic risk by portfolio managers when their primary objective is maximizing risk-adjusted returns? It might start with the recognition that relatively few companies and industries can catalyze a widespread financial crisis. We learned that lesson in 2008 when a handful of financial institutions precipitated one. One would, for example, look to energy or banking before apparel or food and beverage.

These companies could be identified by an independent research organization as, say, the “Systemic Risk 200.” Such a list would help investors make buy/sell/hold decisions having a systemic risk perspective. It also might give rise to index strategies that tilt investment exposure away from companies or sectors whose financial or operational demise might reach across global markets and asset classes.

Another question to ask is whether investments in real assets, infrastructure projects and companies having long-term climate positives can provide a buffer against a climate-induced financial crises by being less susceptible to panic selling and better prepared to compete in a new economic environment.

Perhaps the most effective way to elevate the connection between specific portfolio decisions and systemic risk factors is disclosure: how might catastrophic failures in judgment, business strategy or operations of a company, or the industry they are part of, imperil the larger financial community and society as a whole. In the case of climate that could be in the form of more robust climate risk disclosure already required by the SEC or voluntary disclosure standards established by the Financial Stability Board, and would include the consequences of underestimating stranded asset risk, technology shifts and enactment of regulations that would limit or tax GHG emissions.

Most investors will say they have a hard enough job evaluating risks that directly impact their portfolio companies without layering on additional criteria to capture systemic risk. Consequently, a useful ‘Step One’ would be to identify the highest probability contributors to systemic risk. A lighthouse, where none exists now, could alert investors to some systemic risks not entirely visible and help keep our economies buoyant and off the worst of the rocks.

Peter Ellsworth is Director, Investor Program, Ceres.

Have your say: comment on this response and the original article: ‘It’s time for investors to start reporting on both portfolio and systems-level performance at RI’s Linked-in site.