JEDDAH: Sudden withdrawal of liquidity from markets leads to potentially very large losses on leveraged strategies, a new study from the Research Foundation of CFA Institute said. To ward off this situation, one must consider carefully the magnitude of losses before moving into any drastic reversed action, it noted. The study came up with a series of recommendations to improve business practice in the investment management industry after the financial crisis has affected and continues to affect it. Domluke Da Silva, an executive committee member and chair-advocacy for the CFA Emirates society said: “This new study is very important for the investment management industry, and in particularly relevant to the finance sector in the UAE, as we continue to become more and more integrated into the global financial & investment community. There are valuable lessons to be learnt as well for investors in the region as many were affected by the crisis. Pertinent issues such as the dynamics of asset allocation, diversification and correlations, the importance of having a global view on the investment environment, marketing of structured derivatives products and ethics all have significant ramifications for investors, whether investing out of or into the region. “ Focusing on what the industry has identified as challenges in the post-crisis period, such as asset allocation, risk management, management fees and the redistribution of roles in investment management, as well as ethics and regaining the trust of the investor, the study further suggests that for effective diversification, consider correlations at the relevant time horizons. Instantaneous correlation between the returns of different assets and asset classes does not fully reflect the behavior of the returns of assets or asset classes in times of crisis, when there can be shifts in medium-term trends or an increase in correlation at long time horizons. Moreover, it urged review of asset allocation more frequently. “Today's markets experience more large swings in market valuations and change behavior in fundamental ways that affect the forecasts of entire asset classes and require dynamic asset allocation.” Yet, while dynamic asset allocation holds the promise of higher returns, it is a source of risk given that it shifts assets dynamically from entire asset classes, leaving little margin for mistakes in timing, it added. It also said that hidden sources of extreme risk have to be accounted for and “these facts need to be incorporated into financial decision-making.” One should also consider the complexity of the web of relationships between agents and between investment products. The structure of market links has come to the forefront as a source of risk as complex derivative products might propagate losses throughout the economy well beyond what was believed realistic before the 2007-2009 crisis, the study pointed out. Looking at macroeconomic quantities as the “real economy does matter,” it added. Though macroeconomic variables move slowly, they are important insofar as they can signal the building up of situations that might lead to large losses. The study warned that hedging strategies can fail given that apparently solid counterparties can and do fail. “With the crisis that started in 2007, hedging has acquired a new dimension as the possibility of failure of counterparties such as major banks and insurance firms has increased beyond what was considered likely before the crisis,” the study noted. The study recommends the building up of multi-asset and multinational capability. “Markets are global and investors increasingly expect those who manage their money to have a global view on the investment environment.” Strengthening of quantitative capability to address the size and complexity of markets as “optimal execution increasingly calls for automation and quantitative capabilities.”
