The interventions of central banks following the global financial crisis of 2008 and the Covid-19 pandemic will have a significant impact on financial markets over the long term, according to Unigestion’s Fiona Frick. 
Frick (pictured), the asset manager’s chief executive, said the scale of support from central banks aimed at saving the global economy has had an impact on the financial concepts that have been studied and applied “for decades”, such as portfolio construction and the influential ‘modern portfolio theory’.
First conceived in the 1950s by Harry Markowitz, modern portfolio theory provided investors with a means to measure risk and diversification, said Frick, and allow them to quantify the benefits of adding new exposures.
“While modern portfolio theory was a dramatic leap forward in financial thinking, we believe many of its foundational assumptions hold with difficulty in real life,” she said. “This is especially true in the current environment, where large-scale quantitative easing has structurally modified the relationship between assets’ risk and return expectations.”
The “massive evolution” of fiscal and monetary policy that started as a result of the global financial crisis and has been accelerated during the pandemic means that the very nature of risk has changed.
As such, investors need to move away from traditional risk measures – such as historical volatility – and instead focus on ‘true risks’ such as permanent loss of capital.
To do this, investors need to understand the “multi-dimensional” nature of risk, said Frick, and take an active approach to risk management taking account of key risks, including: credit, government intervention/financial repression, liquidity, and ESG (environmental, social & governance).
On credit risk, she warned that while central banks' quantitative easing and fiscal policies have helped survive an economic decline “that would otherwise be devastating”, they could also have serious side effects in the future.
“Credit risks are growing in the economy due to credit misallocation and increased solvency risks,” she explained. “We are experiencing a situation in which many countries and companies, already highly leveraged, are taking on more debt.”
Frick said investors have favoured companies that use debt or implement stock buybacks to improve profitability in recent years. Yet the pandemic has shown that prioritising profitability can create fragility in markets.
“Fundamental ratios that have been forgotten over the past decade, such as debt-to-equity, interest coverage and cash flow robustness, will move centre stage,” she added.
The risk of government intervention or financial repression must also be considered, said Frick, as the huge sums of government debt accrued during the Covid-19 crisis will need to be repaid – whether through higher taxes, inflation or other means – which could have implications for asset allocation.
“In emerging markets, government regulations, such as de facto caps on profits for utilities, have been quite common, but we could now see similar situations arising in developed countries across various industries, such as utilities, automobiles or airlines,” she said.
“This new type of risk, which econometric models can only assess retrospectively, highlights the importance of combining systematic analysis with forward-looking fundamental research.”
While volatile, liquidity risk “generally strikes at the worst of times, so it is better to be prepared for it”. In March and April, there was an unprecedented liquidity crisis in financial markets where even government bonds were impacted, highlighting how critical it is to portfolio construction.
Finally, ESG risk is becoming an increasingly important consideration for investors as awareness of these issues continues to grow.
“Companies that do not pursue sustainable practices on a day-to-day basis create operational and reputational risks within their businesses and to their business model,” said Frick. “Meanwhile, new regulation can make or break entire industries and can have a direct impact on the companies in which we invest.”
Another key concept that needs to be revisited is diversification – a cornerstone of investing since Markowitz published his article on portfolio selection in 1952, according to the Unigestion chief.
“The benefits of diversification across assets have been challenged over the last 10 years, when few strategies would have beaten a simple 60/40 portfolio comprising US equities and government bonds,” she said.
“The magic behind diversification is that a portfolio of assets will always have a risk level less than, or equal to, the riskiest asset within the portfolio.
“The theory has its shortcomings, however, and unfortunately, diversification can fail dramatically during market crises, just when investors need it most.”
This has been exacerbated during the pandemic when there has been an “unprecedented rise in correlation between different asset classes”, she said.
“Certain assets have fared better than others, but the list of winners during the initial sell-off was very short and bonds did not offer the level of protection they have in the past, in part due to their low level of yield,” said Frick.
Furthermore, diversification across global equity markets did not pay off as global stocks once again behaved in similar fashion, having been impacted by structural changes such as the rise in passive strategies, high-frequency trading and factor investing.
Nevertheless, the failure of diversification more recently is likely to be a cyclical phenomenon caused by central bank action, according to Unigestion’s Frick, and it expects correlation and dispersion to favour diversified portfolios after the current crisis.
She added: “Generally, diversification does not tend to pay off during the first leg of a significant market correction, when systematic de-risking negatively affects all stocks indiscriminately, but we expect more dispersion to materialise in the coming months.
“Furthermore, prior to the Covid-19 outbreak, economic growth had been the key driver of market performance for more than a decade. This should change as we move into a more volatile economic environment that should be discriminatory in terms of countries, sectors and styles.”