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Two black swans since the turn of the millenium

A lost decade for equities The disappointment is huge – investors who have invested in equities by means of a «buy & hold-strategy» did hardly earn the returns they have hoped for in the last thirteen years. The investor was not properly compensated for taking the higher risk of equities.

Reason: Two black swans Since the turn of the millenium, we experienced two highly unlikely events (so called black swans): The burst of the dot.com bubble in 2001 and the worldwide financial crisis in 2008.

Losses come quickly, profits take their time A stock market crash leads to high losses in a short time period: During the financial crisis, the MSCI World index fell by around 50% in one year. In order to regain those losses, the stock market hat to gain 100% - which took more than four years.

Crash and recovery of the global stock market (MSCI World; illustrative)
Crash and recovery of the global stock market (MSCI World; illustrative)

Good equity returns if black swans are avoided

But there is some good news! Studies have shown that the historic equity risk premium (vs. treasury bonds) of approx. 4-6% p.a. could have been earned during the last thirteen years – provided that those «black swan» events had been avoided. Investors who anticipated the risks and reduced the equity quota in their asset allocation were adequately compensated for taking equity risks: While a «buy & hold-strategy» on the MSCI World index returned an overall loss for the last thirteen years, a profit of 13.2% p.a. could have been realised if both crashes would have been avoided.

Global stock market (MSCI World) with and without crashs (illustrative)
Global stock market (MSCI World) with and without crashs (illustrative)

Finreon Tail Risk Indicator (TRI): The systematic risk engine

How to detect a big crash? The Finreon Tail Risk Indicator (TRI) was developed exclusively by Finreon and allows to identify market regimes with high or low «crash»-risk. For this purpose, a broad variety of different market factors are analysed systematically and on a daily basis. The result – the risk of the prevailing market regime – is shown as a risk signal light: Red for high risk, yellow for normal risk and green for low risk. Accordingly, the equity allocation is reduced in a red regime whereas the equity exposure is increased during a green regime. Applying this strategy to the MSCI World index, a return of 8.2% p.a. could have been realised during the period January 2000 – September 2013, while a «buy & hold»-strategy resulted in a 0.6% p.a. return - and this with a significantly lower risk.

Global stock market (MSCI World) and the detected risk phases (simulated, live since 2011)
Global stock market (MSCI World) and the detected risk phases (simulated, live since 2011)

Applying the Finreon Tail Risk Indicator

The Finreon Tail Risk Indicator can be used for controlling the risk of an entire portfolio or for managing an equity allocation bandwidth. In the case of a risk controlled portfolio, the equity quota, ranging e.g. between 0% and 100%, is controlled by the risk signal. In the case of risk controlled bandwidth management (a combination of a pro-cyclical and anti-cyclical approach), the signal controls the equity quota within a given bandwidth. The Tail Risk Indicator is also very flexible in terms of implementation: The investment can be undertaken via the Finreon Tail Risk Control® fund or mixed mandates. Furthermore, the signal may also be applied on different regional allocations.

Applying the Tail Risk Indicators (illustrative)
Application of the Tail Risk Indicators (illustrative)

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Risk Control Solutions: Overview