Longer-term inflation risk has become a concern for pension funds and other long-liability institutional investors.
At a roundtable discussion on the subject of risk management organised by AsianInvestor, Heman Wong, investments director at Hospital Authority Provident Fund Schemes, said market participants have become too complacent about inflation, given its historical volatility.
"For years everyone agreed volatility in equity and bond markets was too low, but no one did anything about it, and today I don't think we can assume it will return to pre-crisis levels," Wong said.
"In the same way, we've seen inflation in the US come down from 13% to 2%, and people in the market assume the Fed will keep it low. But is this assumption correct, given the amount of money being created by the US government? We need to prepare for the possibility that inflation will come back."
Stuart Leckie, investment actuary at Stirling Finance, argued that for pension funds, the biggest long-term risk is to lose out against inflation. "Inflation will be a far bigger problem in the next few years than any of us realise," he warned.
Investors must not be so cowed by turmoil in financial markets to forget this, he said. Maintaining a long-term focus is critical.
Leckie recalled: "There've been many scary moments in Hong Kong -- uncertainty over 1997, Tiananmen in 1989, the stock market crash in 1987, an even worse crash in 1973 when the Hong Kong market fell 93% in a short space of time. Every time, equities eventually recovered."
The crisis has underlined the importance for investors to lengthen the time horizon when considering risk. This has a direct impact on the tools they use to measure risk.
"We all think of volatility as a measure of uncertainty, of things going wrong," observed Carl Moss, CIO at Intech, a unit of Janus Capital. "But in the long term, it's a direct impact on the bottom line of the value of your investments. It's a simple matter of compounding. If an asset's value falls by 50% you need 100% to get back to where you were. In the past, people thought of volatility as a short-term issue that could be measured by something like VaR [value at risk]. But it's actually a long-term issue."
Measurement tools such as VaR have also faced renewed scrutiny. They remain valid but only so long as they are better understood.
"When investors look at their strategy, the focus for many years has been to focus on downside risk," noted Naomi Denning, head of investment consulting for Asia-Pacific at Watson Wyatt. "A common measure is VaR [value at risk], the 95th percentile. Perhaps there was an awakening about what this means: the 95th percentile of expected range of outcomes. The reality is there is another 5% beyond that, and what people realised in this crisis is they need to understand what lies in that 5%, and how bad the tails can be."
She adds that investors are incorporating longer-term risks, such as the possibility of stagflation, into their models.
For now, Hospital Authority is putting more resources towards trying to understand longer-term challenges and ways to deal with them, and outsourcing more of the basic manager-selection work.
"My team spends its time asking whether we want exposures to inflation-linked bonds, property or commodities as an inflation hedge," says Wong. "It's easy to say yes, we need such a hedge -- but when gold's at $900/ounce, is this the right time? Why is gold at such a price? These things are not easy to answer."
The full transcript of the roundtable discussion is available in the September edition of AsianInvestor magazine.