Stress testing is becoming an essential risk management tool for asset managers. Relying on systems that only capture routine market volatility are no longer deemed sufficient; the notion that running stress tests involves nothing more than applying a shock to a portfolio or running it through a historic period has been firmly discredited.

This was particularly true after 23 June when, according to Axioma chief operating officer Ian Webster, deciding what assumptions to make post-Brexit could not be guided by precedent. “There is only one historic event that is similar in nature and that is Greenland leaving the European Union in 1985, but the magnitude of that event is not comparable to the UK leaving the EU.”

Potentially comparable scenarios include the near break-up of the single European currency as a result of the Greek debt crisis or the UK exiting the European exchange rate mechanism in 1992, but analysis of these periods produces wildly different results.

Webster observes that in the run-up to the EU referendum, a stress test based on the European bond crisis (where over a period of three months the equity market fell by 24%) was highlighted. “But analysis of the ERM stress test revealed that equities rose by 18% over the following quarter, so what looked like very similar types of macroeconomic events ended up producing very different outcomes.”

Damian Handzy, founder of investor analytics & global head of risk at StatPro, accepts that it was a lot easier to come up with a stress test and an estimate of how markets might react initially to Brexit than to predict the impact of the vote six months down the line as there is no single trigger event that will take place over that time period.

As it happened, risk management processes responded well to the aftermath of the referendum. “The FX and equity markets were shocked but they were orderly,” observes Dr Laurence Wormald, head of research & quant investment risk at FIS. “Only in the less liquid commercial funds market did problems arise, with withdrawals having to be gated.”

Risk scenarios

Risk scenarios that have come to the fore include the impact of terrorism and other geopolitical instability on particular asset classes and issuers, particularly ones that have exposure to both UK and European markets. “Increased focus and emphasis on currency exposure is also being considered,” adds Alpha FMC director, Greg Faragher-Thomas.

When it comes to sector-specific positioning, Webster suggests that managers are looking more closely at correlation assumptions and ensuring that they are correct, particularly if an enterprise-wide perspective is being taken rather than just a portfolio-level view.

According to Handzy, interest in sector-specific investment rose in the wake of Brexit, particularly in relation to sectors such as banking, on the back of suggestions that UK banks could be subject to less regulation.

He says there is general agreement among asset managers that a robust model for measuring liquidity risk has yet to be developed. Many regulators have focused on the number of days to liquidate as a measure, but that approach has been criticised because assets can be liquidated more quickly if the owner is willing to accept a significant haircut.

“Days to liquidate is affected by the price you are willing to accept for the asset you are trying to sell or the price someone is willing to pay,” continues Handzy “The credit crunch gave us a good indication of how the industry would react to a collapse in liquidity – there was a flight to quality and holding cash.”

Although equity markets are highly liquid, Webster accepts that further research is required to determine whether they have the ability to bounce back in the event of circular asset movements. “Asset managers face challenges when marketing illiquid assets in liquid funds and passive investments exaggerate some of the issues because you are turning individual assets into 100% correlated assets,” he concludes.