Asset bubbles driving equities and real estate asset prices have been observed as the direct outcome of sustained zero interest rate policies, particular in the US and EU over the last 10 years. Even as interest rates are rising, an even greater threat hasn’t been highlighted – the inability of financial risk models in banks, asset managers and financial advisors to accurately understand and forecast how investments, indices and markets will react to rising rates. Their risk models are vulnerable because a decade of zero interest rates have never occurred before in financial and economic history. No one possesses accurate historical data to predict the future. And quantitative models and algorithms heavily depend on historical data for forecasting risk. “There are no models that are able to accurately capture the effect of rising interest rates. You need to reach back to the period before quantitative easing began,” said Axioma’s managing director Olivier d’Assier, pointing out the key finding of the risk consultant’s research. “Even if you use the effect of rising interest rates on equity prices in the period from 1994, they won’t reflect today’s correlations as the market was different. You can do this for the US stock market, but not for the EU as there is no similar historical data available for the Euro.” This poses potentially disastrous implications for portfolio and risk management if and when interest rates surge and return to normal after a decade of distorting asset valuation. The absence of normative market risk pricing and historical interest rate data disturbs the entire way so called “Alpha” (excess returns) has been hunted by asset managers. Today’s latest quantitative trading strategy, driven by widely available and powerful technology, is to seek Alpha spread over a large number of stocks. However, these differences can be arbitraged away quickly. The ability to scale Alpha and its signals over a large number of stock has its limitations. In response, good managers change the signals they look for. Bad ones retain the same signals and eventually lose Alpha by adding money to an already crowded trade. Contrast that with the traditional, Warren Buffet style search for Alpha through one stock at a time since the 1970s. “Alpha has been compressed since the days of Benjamin Graham and then some has been replaced with systematic factors packaged by asset managers as ‘smart beta’ platforms. This explains why even Buffet has told his heirs to invest in index funds. It’s harder to find Alpha in single stocks over the long term, d’Assier said. The perception is that events don’t seem to alter the direction of economies. Brexit fears have been downplayed. And US equity valuations remain at historic highs. The entire phenomena implies that risk today is widely spread out, but not fully understood across asset classes Today’s risk models are built for shorter term investment horizons compared to the fundamental, long term investment strategies advocated by Graham. The data shortcoming is also exacerbated by the steady growth of passive funds that are designed to track indices. Their managers do not sell positions in reaction to news. Holding passives explains why the index fails to react. Although a majority of equity funds still employ active strategies recently, 80 per cent of fund flows have gone into passive and 20 per cent into active funds, which highlights the popularity of passives. BlackRock and Vanguard are the two largest passive fund managers with US$9 trillion under management. This concentration only worsens the lack of reactive signals in market indices. This explains why the current market has not been too volatile despite recent events. The market is choosing to ignore geopolitical risk. The perception is that events don’t seem to alter the direction of economies. Brexit fears have been downplayed. And US equity valuations remain at historic highs. The entire phenomena implies that risk today is widely spread out, but not fully understood across asset classes. “Gold may be the only negative hedge left for investors,” said d’Assier. Active equity and hedge fund managers face serious competition generating Alpha and attracting investors. Modified smart beta products – a mix of passive and active tactics – has put pressure on the pure active space. Trends toward multi-asset class solutions have been adopted by most shorter term liability driven investors. Like other investors, they have failed to produce any yield in a decade long period of near zero interest rates. The result is a distorted environment for price and value discovery where Alpha is harder to obtain and the lines between asset classes are blurred. Peter Guy is a financial writer and former international banker.