A critical and neglected factor of investment performance
Systemic risk in finance refers to the probability of the financial system failing at its essential functions, such as providing credit, making markets, or safeguarding securities and deposits. Typically, systemic risks build gradually over many years but materialize abruptly. They are hence a cause of extreme endogenous or setback risk (view summary of setback risk here) with rare incidences. Since years or decades pass between systemic crises, with many bonuses being awarded and vesting in the meantime, systemic risks are easily neglected in the day-to-day dispositions of investment managers.
However, how a manager prepares for and deals with systemic risk often makes or breaks long-term performance. Most investment strategies rely on some combination of directional or alternative risk premia and estimations of absolute and relative value. The basic principles of these are common across institutions. A systemic crisis typically derails all of these at the same time. This is because, in contrast to normal market drawdowns, systemic pressures trigger funding, accounting, or legal constraints that force position liquidation with little freedom of choice for portfolio managers. When a systemic crisis escalates the priority of institutions shifts from seeking returns to short-term capital preservation. As a result, the principles of efficient positioning or flows are often not only suspended but reversed. The best positions become the worst. With forced liquidations in thin liquidity, the trades that offered the most convincing value positions (by conventional standards) suddenly incur the greatest mark-to-market drawdowns. This happens because the expected return in the asset management industry is correlated with positions in normal times; good opportunities are rarely secret for long.
Moreover, standard risk management techniques fail in systemic crises. As volatility is soaring and correlations “all go to one”, positions that were calibrated according to value-at-risk give rise to unsustainable mark-to-market profit-and-loss volatility. Hedges may reduce average directional risk but give rise to large “basis risk” (profit and loss swings due to disparities in the returns of the main positions and the hedges). Also, as hedges typically raise the leverage of positions they make trades even more susceptible to forced deleveraging. Finally, diversification is of little help because the scope of inefficient flows is wide. Empirical research shows that a single global financial cycle floats or sinks most markets at the same time. (view post here).