No one could have foreseen the degree to which COVID-19 would disrupt lives, economies, and markets worldwide—or could we have? And how can risk managers hope to hedge against future black swan events, those highly rare, high-impact, and widespread occurrences that shake up global markets and are only obvious in hindsight?
In FactSet’s latest research with Forbes Insights, we investigated how prepared asset managers and owners were for a pandemic on the scale of COVID-19. How agile, creative, and successful were global executives and their firms in crafting their response to a crisis that has disrupted lives, economies, and markets worldwide? What strategies, technology, and tools contributed to positive results—and what hindered performance?
In this series, we explore findings that tell us how shifts in risk technology, models, and enterprise solutions will contribute to future preparedness, and we’ll review the ways in which COVID-19 has driven risk managers to think differently about risk itself.
The Importance of Rigorous and Comprehensive Stress Testing
Market disruptions set in motion by COVID-19 exposed a wide range of weaknesses in risk management strategies and processes. Fifty-one percent of survey respondents who experienced poor performance during the pandemic reported that their risk management systems failed to deliver early warning signs. Forty percent also said the limited degree to which risk analysis was embedded within their investment process inhibited performance during the COVID-19 crisis.
The pandemic, “particularly in terms of its timing and how fast it swept over the globe, was indeed a ‘black swan’ event,” says FactSet’s Dr. Boryana Racheva-Iotova, senior vice president and senior director of research, risk, and quantitative analytics.
Going forward, firms will need to be better prepared for an era of even higher volatility with structural breaks. Indeed, over 80% of respondents agreed that there would be moderate to high volatility over the coming year at least.
To prepare themselves, organizations must introduce more rigorous and comprehensive stress testing. Indeed, more than seven out of 10 firms found stress testing and scenario analysis to be highly useful and effective in the throes of the pandemic. For executives making risk management adjustments, stress testing was also ranked as one of the top three tools and strategies that improved performance during the crisis.
The survey findings, along with added context and expertise from Racheva-Iotova, lead us to three key ways organizations can make their stress testing efforts even more fruitful.
1. Expand Analysis to Include Black Swan and Fat-Tail Events
So much of the disruption wrought by the pandemic stems from factors beyond the boundaries of traditional stress testing. In particular, many of the market distortions were driven by political, social, and even climate-related factors, the analysis of which was beyond standard industry practice at the time of the outbreak.
In 2021 and beyond, firms will need to expand stress testing to include all of these and more. Indeed, 62% percent of the asset managers and owners surveyed agree that stress testing and scenario planning need to address more “black swan” and “fat-tail” events. Firms also say that going forward, uncorrelated stress tests (48%) as well as stress tests based on economic events (46%), customized portfolios (46%), and historical events (45%) will remain critical. Perhaps most interesting is the fact that traditional stress tests based on market events went from being considered the most critical before the crisis (67%) to the least critical (39%) going forward.
Traditional stress tests based on market events went from being considered the most critical before the crisis (67%) to the least critical (39%) going forward.
Such analysis will require a wide range of new data sources and the adoption of technologies, like machine learning and natural language processing, which will enable firms to listen for early warning signs.
All of this will significantly change the complexity of risk management and stress testing. “We’re no longer only speaking about the correlations between the different risk factors or risk drivers,” says Racheva-Iotova. Instead, many of these new factors represent issues where causation—not correlation—is the dependency driver that must be detected and evaluated. This brings a new challenge in “trying to account for those non-financial, more holistic types of risk. We have to quantify them, translate them into financial risks, and then evaluate how these can impact our investment strategies,” explains Racheva-Iotova.
It will be particularly important for the analysis to dive deep enough that it can assess potential impacts with regards to specific strategies and allocation decisions. As Racheva-Iotova adds, “This might be causing new types of dislocations between different asset classes or markets.”
More specifically, this is not only about assessing the potential severe events with regards to the returns on different assets or markets, but stress testing should also explore the very structure of the markets themselves. “We should be seeing stress tests on the correlation between different markets or asset classes, stress tests on sensitivities, and dislocations in the sensitivities of the assets toward different risk factors, and so on,” says Racheva-Iotova.
2. Make It Actionable by Factoring in Plausibility
These levels of stress testing will be remarkably demanding and not only require effort from executives with deep expertise but also significant investment. To ensure organizations make the most of their investment, the analysis needs to be actionable, which can be challenging.
To ensure organizations make the most of their investment, the analysis needs to be actionable.
It can be imagined, for example, “that a firm will run a very broad set of stress tests with each looking into different scenarios and issues,” says Racheva-Iotova. But varying exercises will likely lead to different or conflicting conclusions pointing to one, two, or three asset classes or strategies contributing the most to the firm’s risk. Organizations may ultimately struggle, realizing they cannot act in full measure on every scenario.
But as Racheva-Iotova explains, “seeing everything as dangerous so that you don’t know which direction to move misses the point of the exercise.” What becomes vital, she continues, “is finding ways to assess the plausibility of those stress tests. Run the stress test by plausibility, then try to measure the possible timing of the occurrence of these tests in order to build an action plan.” What results “is a hierarchy of potential allocations and investment decisions that can be implemented immediately should a given stress arise.”
3. Engage the Enterprise as a Critical Element for Performance
To be actionable and meaningful, stress testing also needs to be conducted in a collaborative, open, and ongoing manner. Certain tests will look at enterprise risk, while others can be developed to look at the risks associated with more discrete investment strategies or asset classes.
But whether the risks being tested are firm-wide or more isolated, in all cases, the analysis should be “augmented by using the knowledge, understanding, and investment depth of the portfolio managers themselves,” says Racheva-Iotova. By bringing a firm’s leaders and assorted experts into the process, not only will the outputs have more meaning and more buy-in from the organization at large, but specialists “will also be able to provide additional scenarios, risk factors, and data sets based on the asset classes, markets, and strategies that they’re running,” says Racheva-Iotova.
Indeed, 43% of those whose risk management tools performed well during the COVID-19 crisis say that their efforts to instill a holistic approach to risk management played a significant role in improving performance or at least reducing losses during the pandemic.
Similarly, 43% indicated that collaboration between risk managers and those making investment decisions helped improve performance throughout the COVID-19 crisis.
To succeed in risk management and stress testing, the goal is a very solid dialogue between risk oversight and investment professionals.
“To succeed in risk management and stress testing, the goal is a very solid dialogue between risk oversight and investment professionals,” says Racheva-Iotova. “The essential point is to find a way to have these groups working together.”
While no one could have foreseen the speed and severity of the pandemic, companies must learn from it. The aftermath of the crisis provides an opportunity for firms to expand their data sources and accelerate their analytical processes in order to perform more effectively. We live in an era of rapid change and heightened risk. Stress testing must adapt to this new normal.