We are in the midst of historic times, as sovereigns hang on the edge of default, the inflation/deflation debate remains unresolved and gold trades at a historic high. As a manager or director of a pension fund, this is a critical juncture to understand what can go wrong for your fund in particular scenarios. To help determine potential outcomes, portfolio stress testing may be appropriate.

One form of stress testing is a historical test. Plug in the fund’s current portfolio of assets and liabilities into a historical scenario such as the 1987 stock market crash or the 2008 credit crisis and discover how the fund would perform if such a crisis were to erupt again. While this approach is fairly simple and easy to implement, it lacks depth. The likelihood of an exact replication of a particular historic event seems quite distant.

A second approach would be more involved and difficult to implement, but it can reveal hidden risk in a portfolio. Most risk measures in a typical portfolio risk report contain static variables such as the correlation between assets or asset classes. In a stress test, correlations are pushed to extreme levels (+1 and -1) to reveal tail scenarios. Under these conditions, it is useful to run a simulation of potential outcomes to reveal the likelihood of significant negative returns under certain correlation values. A second value to stress test is volatility, to investigate how a portfolio would perform if volatility spikes. Combining changes in volatility with changes in correlation will increase the number of simulations required but, once again, will uncover portfolio weakness.

A third approach, which is similar to the historic approach, is to generate scenarios to test. This takes far more effort but does not constrain analysis to historical events. It also creates a mindset for all personnel involved in the process to imagine how events will unfold in the future and what implications these events will have on the fund. For example, imagine a US default scenario: how will the Canadian dollar trade relative to the USD (one would assume stronger)? What about versus the euro? Will bonds sell off and by how much? What will happen to commodities such as gold and oil? How will equities react? These are just a few of the questions that should be asked in order to generate a number of potential outcome scenarios and to test the resulting impact on the fund.

A portfolio should endure regular stress testing in order to reveal potential weaknesses or soft spots. There are several potential methods for stress testing with varying levels of effort and time commitment. As one would imagine, additional effort will provide a more comprehensive understanding of the fund’s risks and will create greater dialogue with respect to how world events may unfold and the resulting impact on various asset classes.

Copyright © 2021 Transcontinental Media G.P. Originally published on benefitscanada.com

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