Lessons Learned from Lehman Brothers’ CollapseOct 9, 2018

Key Points

We are now ten years on from the collapse of Lehman Brothers and the Great Financial Crisis (GFC). Those were trying times for everyone, especially investment professionals like myself and our team. But after the dust had settled and the worst of it was over, we saw the opportunity to improve and evolve our own investment process and portfolios.

Lessons learned

In retrospect, the GFC could be seen as the perfect stress test. It gave us the opportunity to better understand how we should build and manage portfolios that pushed the evolution of our own processes in three key areas: macro research, portfolio construction and risk management.

Lesson #1: Macro research

In an era of 24/7 news, it can be difficult to see the forest from the trees. Individual events that appear idiosyncratic on the surface can actually be symptoms of a greater macro trend. In retrospect, the US housing market itself was not the heart of the issue, but rather the amount of leverage tied to it. The leverage within the shadow banking system, coupled with individual consumer debt levels tied to housing, were at extremes. This toxic mix caused the massive market dislocation when housing prices weakened.

In our investment process, we try not focus too much on individual daily events but rather the larger themes that may be lurking. For example, are the issues affecting Turkey, South Africa, and Argentina individual idiosyncratic events or a hint that global liquidity is tightening, which may have broader implications?

Lesson #2: Portfolio construction

Going into the GFC, many investors felt they were diversified because they had various equity, fixed income, and other asset class exposures. However, during the panic these correlations broke down and losses exceeded the expectations of many investors.

Looking at asset classes in a more traditional way still makes sense, but we now have supplementary lenses that can help breakdown the portfolio in other ways to test the robustness of portfolio diversification. Below you can see the difference between a traditional portfolio breakdown and risk factor breakdown.

At first glance, asset classes such as US equities and US high yield corporate bonds should provide good diversification benefits; however, they tend to actually be linked to similar risk factors like volatility, inflation and GDP growth. This means they may actually provide limited diversification benefits, especially in times of stress as seen below.

Constructing a portfolio that has strong risk factor diversification and target certain factors during certain regimes is an added step in the process.

Lesson 31: Risk Management

Our risk management systems have evolved to better arm us with a deeper understanding of the risk exposures in the portfolio. The first step in portfolio construction is ensuring a robust strategic asset allocation target to meet the goals of the portfolio. The next step is a more dynamic asset allocation component where we manage the portfolio’s active risk which is coming from overweights and underweights to various asset classes, sub-asset classes, currencies and risk factors.

It is important to understand and manage the active risk being taken in the portfolio. For example, when looking at tactical bets vs. the benchmark, we look at contributions to relative risk (tracking error) to ensure bets are consistent with our level of conviction, and how they are diversified from one another. As can be seen below active risk is being generated from various parts of the portfolio.

The data can be broken down further in many ways. For example, we could break fixed income exposure down as follows:

Unsurprisingly to us, most of our risk budget is being spent with our underweight position to duration (Curve a contribution of 27.1% of our total tracking error), with other parts of our risk budget being overweight credit (4.3% of tracking error). The inflation and securitized factors are not contributing much to active risk. Seeing a top level overview of overall contributions to risk in the portfolio has helped us ensure active bets are intentional, sized correctly and diversified.

Advice to investors

Turn off Bloomberg from time to time! Instead, try to focus on relevant data that confirms or challenges your investment theme(s) and try not to get caught up in the 24/7 news flow. Have a macro process that allows you to manage and filter incoming data to focus on what is most relevant.

Understand not only the underlying drivers of risk in your portfolio in traditional sector, country, currency allocations, but also the underlying risk factors exposures. Test the interactions of these risk factors to ensure the portfolio is not driven too much by any one factor or tied to any one macro theme, but is properly diversified.

When looking at the risk of your portfolio, either absolute or relative, check that the contribution to your risk is coming from where you think it is. Take active risk where you have conviction, but measure it to ensure it doesn’t dominate the portfolio.