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RISK - The only way to achieve the returns Robert Kitt, PhD Researcher, Centre for Nonlinear Studies CEO, Hansa Investment Funds Risk from different perspectives • Industrial data – risk is measured with standards – Mechanical, chemical, electrical and environmental standards – Zero-tolerance in risk management • Philosophical data – what is the risk of scientist? – – – – Not being published? Not being read? Not being listened? Not being cited? • Historical data – risk is assessed from the past – Mortality table in the life insurance Definition of risk • Risk is the situation of the concious individuals where they are exposed to the uncertain factors • Since we cannot be aware of exposure NOR all of the affecting factors, the risk cannot be generally defined • One can define and measure only the certain perceived component of the risk – be it credit quality, volatility, etc • Therefore, it is worthless to ask wheither any risk metric measures the risk, but one should ask: is the metric useful? Types of risks 1/2 • Market risk – risk, that fluctuations of the financial markets have negative effect to the value of our investments – Intrinsic part of any of the investments. There are countless amount of factors to affect the security price: economic factors, interest rates and inflation movements, politics etc – Scale of measurement: standard deviation of returns • Business risk – risk, that the issuer of the security is financially not in good shape – This type of risk can realize in the drop in share price or decreased dividends etc. • Inflation risk – risk, that the return from investments does not exceed the (consumer) price inflation – Historically the bonds have had periods of sub-inflationary returns – Scale: relative performance • Interest rate risk – risk, that the value of the debt security can decrease because of increasing yields – Scale: duration Types of risks 2/2 • Credit risk – risk, that the borrower cannot fulfill its obligations – Credit risk stands for both: financial inability and for organizational unwillingness – Scale: credit rating • Currency risk – risk, that the value of the investment can decrease because of currency fluctuations – Scale: standard deviation • Political risk – risk, that the value of the investment can decrease because of the changes political and/or regulatory environment – Political risk can realize through increased taxes, capital controls, currency devaluation, revolution etc – Scale: credit rating • Liquidity risk – risk, that investment cannot be sold at reasonable time for reasonable price – More “exotic” instruments are more exposed to the liquidity risk. These a re investments that have only limited amount of supply/demand How to manage risks? • Self-education – one has to understand what risks are taken and also are all of those risks accepted – Consult with the advisor Find the right scale for risk assessment • Diversification – the portfolio of different investments reduces the importance of single risk factor to the overall portfolio • Focus on the goals – the shorter investment horizon, the more important is the market risk (i.e. Fluctuation of the portfolio) • Think for the future costs – long-term investors bear more market risk, but they are more exposed to the inflation risk. • Consider the current income – mostly the bonds offer the disposable cash flows from the portfolio How to measure the risks? • Modern financial theory assumes that the returns of the securities are independent in time and they are also normally distributed • Standard deviation is the statistical measure, that describes the average deviation (error) from the average empirical result (e.g. average return) • Majority of the econometrical models are based on the Gaussian (normal) distribution, or at some variation of it (e.g. Log-normal distribution). The risk measurement models are no exceptions: – Value-at-Risk – Ex post and ex ante tracking errors • Econophysics offers more precise measurement tools – The probability of market crashes by conventional models is zero! – The memory in time series: multifractal processes Measurement of risks: standard deviation Average Risk Annual return (st.deviation) Large Cap Stocks 12.2% 20.5% Small Cap Stocks 16.9% 33.2% US Treasury Bonds 5.8% 9.4% US Treasury Bills 3.8% 3.2% Inflation 3.1% 4.4% Distribution of the returns Source: Ibbotson Associates, 2003 Standard deviation and normal distribution Example: Large Cap Stocks Average return 12.2% Three-Sigma-Rule: 99.74% of the observations are within three standard deviations Complex Systems Are Researched in CENS Departement of Mechanics at IoC • Jüri Engelbrecht, PhD, DSc • Arkadi Berezovski, PhD • Jaan Kalda, PhD • Mati Kutser • Pearu Peterson, PhD • Arvi Ravasoo, PhD • Andrus Salupere, PhD • Tarmo Soomere, DSc • Anatoli Stulov, PhD • Marko Vendelin, PhD, Eng • Olari Ilison, PhD • Robert Kitt, PhD • Kalev Rannat • Maksim Säkki, PhD • Andres Braunbrück, PhD Laboratory of Photoelasticity • Hillar Aben, DSc • Leo Ainola, DSc Institute of Cybernetics at Tallinn University of Technology Centre for Nonlinear Studies (CENS) Keywords of CENS Mathematics Nonlinear dynamical systems Physics Systems out of equilibrium Chemistry Biology Computer Science Economics … Control theory Adaptive and self-organizing systems Complex dynamical networks of interacting units “The whole is more than the sum of the parts” Aristotle http://cens.ioc.ee Hansa Investment Funds: best porfolio for CEE investors Asset Management business of Hansabank in the Baltics • In operation since 1994 – the oldest investment management company • EUR 2billion assets under management - the largest asset manager • More than one million clients and 43% market share in pension – the largest retail client base Experts in • Eastern European and Russian financial markets • Pension fund asset management Assets Under Management Bond funds 5% Institutional portfolios 10% Fund of funds 9% Liquidity funds 7% Pension funds 31% Equity funds 38% Source: Hansa Investment Funds. Data as of December 31, 2007 Hansa Investment Funds serves a diversified group of clients, with each group representing about 5-40% of total assets under management. CEE Region in Europe CEE 11 EU 15 105 385 5.4% 2.8% 14,640 4.0% 29,270 Export growth 10% 4% FDI (% of GDP) 2004 4.8% 0.7% Gov. Debt (% of GDP) 31% 65% Fiscal bal. (% of GDP) -2.3% -2.7% 9.8% 7.4% As of 2006 Population million GDP growth GDP per capita, $ CPI Unemployment rate Source: EC, Eurostat, IMF 2,1% Convergence to EU is the key investment theme Income Levels in CEE Region Are Lower Than in EU15 100% 100% 90% 76% 80% 68% 70% 60% 58% 55% 53% 45% 50% 48% 46% 45% 40% 31% 32% BUL ROM 30% 20% 10% 0% EST LAT LIT CZK HUN POL SLK SLV Income levels in CEE (EU15=100%) Source: Eurostat CRO EU15 Equity Funds Quarter-end AUM 700 Central Asia Equity Fund-48,5 mEUR Eastern Europe Real Estate Equity Fund -146 mEUR 600 Eastern Europe Equity Fund - 216 mEUR Russia Equity Fund - 146 mEUR 500 400 300 200 100 0 12/07 09/07 06/07 03/07 12/06 09/06 06/06 03/06 12/05 09/05 06/05 03/05 12/04 09/04 06/04 03/04 12/03 09/03 Hansa Investment Universe Why CEE and Russian equities are an attractive asset class? • • Central Eastern Europe (CEE ex Russia) – Convergence process – CEE economic growth set to outperform rest of EU – Second wave of enlargement still in progress – Fast earnings growth coupled with low valuations – Inefficient markets, many stocks not covered by sell side research Russia – Russia’s growth troika: capital, labor, productivity – Well supported by current oil and other commodity prices – Emerging sectors besides oil and gas – Strong economic fundamentals The Baltics built three-pillar pension systems Estonian pension reform, introduced during 1997-2002, was based on the World Bank’s three-pillar approach: • • • First Pillar - Pay-As-You-Go system (payments to pensioners from taxes on current workforce) Second Pillar - defined contribution plan with individual accounts managed as pooled funds Third Pillar - voluntary savings plans to provide additional retirement income Latvia and Lithuania developed similar structures Fund of funds add value Equities or bonds? Which region? Pension funds know-how Lower costs than if you were investing on your own FoF Fund selection When to buy? When to sell? Goal: Best portfolio for the Baltic investor! Pension and fund-of-funds is likely to grow furter Assets under management mEUR 4000 3000 2000 1000 0 2005 2006 2007 P2P 2008 P3P 2009 FoF 2010 Private markets in Hansa Investment Funds We invest in: • Corporate debt – • Private equity – – • Debt securities issued by Baltic companies including bonds, commercial paper and subordinated debt instruments Investments in private equity funds Direct investments in private equity Real estate – – Real estate funds Direct property Recognition • In November 2007 the activity of Hansa Private Debt Bond Fund was recognised by Investment & Pensions Europe when Hansa Pension Fund K3 was awarded a theme award as the Best European Pension Fund in Fixed Income Investment. • IPE emphasised how the pooled vehicle has stimulated the issuance of debt in the Baltic countries and made bonds financially more attractive to investors. In addition, its ability to negotiate the terms of fixed income investments and improvement in reporting standards and collateral agreements of new bond issues is noticeable. • Thank you... References: • Risk analysis, R. Wilson, Am. J. Phys. 70 (2002) 475-481 • Defining risk, G.A. Holton, Fin. Anal. J. 60 (2002) 19-25 • Theory of financial risks, JP. Bouchaud & M. Potters (Cambridge UP, Cambridge, 2000) • Generalized Scale-Invariance in financial time series, Robert Kitt, Doctoral Thesis, TTÜ, 2005 • http://www.hansa.ee/funds • http://cens.ioc.ee