For a concept that is so widely used, power is surprisingly elusive and difficult to measure. It is often defined only in undesirable terms, and as a form of domination, but it can also be a positive force for individual and collective capacity for change. For example, the most commonly recognised form of power – power over – has many negative associations for people; such as repression, corruption, force or coercion. Power, in this circumstance, is seen as a win-lose kind of relationship. By way of contrast – power to – refers to the unique potential of every person to shape their life and world. When based on mutual support, it opens up the possibilities of joint action and the building of shared strength.
Behavioural power is a more recent definition and focuses on motivating others to do what they otherwise wouldn’t; it involves the subtleties of agenda setting or framing issues to gain influence and achieve objectives. Social scientists argue we cannot describe a politician, government or state as having power without specifying power ‘to do what’. This should also include the parties involved in the power relationship (the scope of power), as well as what topics are involved (the domain of power).
To this lexicon, there is a new type of power we are all having to become increasingly familiar with – cyber power.
How to define cyber power
Power based on information resources is not new; cyber power is. It reflects a society’s organised capability to leverage digital technology for surveillance, exploitation and subversion. A society wielding substantial cyber power can produce preferred outcomes within cyberspace or it can use cyber instruments to produce preferred outcomes in other domains, outside cyberspace. In terms of the latter, it enables actors to economically exploit or undermine other nations; efficiently gather political and military intelligence; sabotage critical infrastructure and even cause mass casualties.
Cyber power provides the means to destabilise, foster distrust, create disorder and amplify volatility. The graphic overleaf lists the series of high profile cyber attacks instigated through last year and this, targeting both public and private entities. It highlights the need for a heightened appreciation of the risks involved, along with an insight to the costs likely to be associated with building protection against the unseen, the unexpected and the unpredictable.
Source: Rize ETF Limited
Parallels with protecting portfolios
Suffering the consequences of a bad actor exerting unwelcome cyber power remains a low probability, but high consequence event. Buying protection, via cyber security, is a cost – but how much is it worth? More cyber security will never make a quarterly balance sheet look better, nor will it ever produce a surplus budget. Such a cost is also, alas, not a recipe for economic growth or enhanced competitiveness. However, disregarding the risks posed – both from a financial and reputational perspective – is potentially very damaging and justifies the money being spent by governments, corporations and households to protect against it.
Thinking about the unseen, the unexpected and the unpredictable should, of course, be core considerations for investors. Although we all purchase insurance for our homes, travel and health – it often seems less important to protect our portfolios in the same way. Moreover, many take risks believing their portfolios are protected through diversification, only for it to fail when needed most.
One approach to minimising the potential for the permanent loss of capital in portfolios is termed tail risk hedging. In the world of finance, a ‘left tail event’ (loss) is generally defined as a three standard deviation occurrence based on a normal distribution of returns – or something that has a 0.15% chance of happening. Financial market history suggests such losses occur at a rate that significantly exceeds that predicted by this normal distribution.
Incorporating a tail risk hedge has a cost, however, during a tail event, an effective hedge should reduce drawdowns. Over time, the effect of compounding means portfolios carrying an allocation to a tail risk component should outperform those that avoided the cost of holding tail risk protection during good times. Additionally, investment managers using this approach also duck the reputational damage sharp falls in portfolio values can prompt.
Returning to cyber space – aside from the cost of security, another question commonly posed relates to what should be considered an appropriate balance of offensive and defensive cyber efforts? Today, governments are clearly the biggest actors in this arena and public discussion and the forming of opinions on what is an acceptable approach – and money well spent – is very topical. The ‘balance’ expected by societies across different geographies varies significantly, often driven by culture, values and a history of always ‘doing something similar’ in the pre cyber age.
Once again, this debate has parallels with the questions being posed by investment managers right now. Balancing risk-taking positions with offsetting allocations to less volatile and uncorrelated assets – typically bonds – has been the preferred offensive/defensive approach to portfolio construction for decades. However, extreme monetary and fiscal policies have – according to Ray Dalio, founder of hedge fund firm Bridgewater Associates – meant ‘the economics of investing in bonds has become stupid’. He argues that the purpose of investing is to have money in a storehold of wealth that can be converted into buying power at a later date. When investing, we commit a lump sum in exchange for payments in the future. But, if we look at what that deal looks like currently for fixed income investors, the stupidity reveals itself. According to Dalio, based on US$100 invested in US, European, Japanese and Chinese government bonds, it would take roughly 42 years, 450 years, 150 years, and 25 years respectively to get your money back, using 30 year yields. We should note this ignores inflation. If it was taken into consideration, in the US a bond investor would have to wait over 500 years, and would never get their buying power back in Europe or Japan.
To further compound the challenge faced, the ‘uncorrelated’ nature of bond returns and the diversification this brings has started to break down. This, coupled with the tendency of most asset class correlations to trend to 1 during a tail event, further questions the role high quality bonds will play in ‘balanced’ portfolios going forward.
Implications for portfolios
During March, we have seen the unintentional blocking of the Suez Canal; a 15% fall in the value of the Turkish lira; the collapse of a multi-billion dollar US hedge fund and a worsening Covid-19 outlook across Europe. All of these are unrelated, but further highlight the potential risk of the unexpected. Hedging portfolios against these risks requires a set of characteristics including negative correlation, asymmetry, convexity and liquidity in a crisis. When considering what financial instrument exhibit these features – options fit the bill best. However, these require specialist knowledge, credit lines and counterparty agreements to be in place. There are dedicated tail risk funds, although these tend to be relatively expensive, both in terms of fees and capital erosion if no significant risk-off event occurs. Other strategies can include allocating to gold and silver and/or precious metal miners, as well as seeking liquid alternative solutions which provide uncorrelated return sources.
Most developed markets are expensive, hence this is not the time to be complacent – although after a 40 year bull run for government bonds you can understand why there are a lot of comfortable longs. Investors need to challenge their asset managers as to what role fixed income holdings are playing in their portfolios and how diversified their allocations really are. Today, ensuring the power to protect capital is prevalent is an imperative for investors, as opposed to unconsciously letting the market have power over them.
Please do contact us with any questions.
References; Cyber Power, Jospeh S. Nye, RR – Harvard Kennedy School
Julia Warrander and Russell Waite
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