Fathom’s Financial Vulnerability Indicator (FVI) is a comprehensive measure of financial vulnerability, spanning 177 countries and has been developed using state-of-the-art modelling techniques. It is a measure that covers four types of financial crisis: banking, sovereign, currency and sudden stop. It allows us to look at a country’s vulnerability to each of these crises relative to other countries and their own history.
The FVI can be used as a tool to manage risk, understand evolving market trends and identify investment opportunities. Given a view of the prevailing market conditions (i.e. risk on/off), the FVI is uniquely placed to select winners and losers within an asset class.
For example, since the Federal Reserve’s dovish turn at the start of the year, which spurred a risk-on bounceback from the market turmoil of the previous quarter, the emerging market currencies that have fared the best are those that are most vulnerable to a currency crisis according to our FVI score. We also found that the opposite was true in 2018, as then the Fed tightened policy quicker than expected.
However, even without a view about the current risk regime, it is possible to use portfolio construction techniques to systematically gain exposure to markets with more favourable risks, as identified by the FVI. Building on the nascent literature that applies machine-learning techniques to financial problems, we combine the whole of our FVI dataset, which includes a combination of fundamental economic data and high-frequency financial data, with novel clustering techniques to group countries based on their fundamental, underlying risk profiles Allowing an algorithm to pick the most salient common trends across a wide set of fundamental characteristics provides a richer set of information, and a better quality of diversification, than using mainly market prices as the principal information set.
Increasingly popular ‘smart-beta’ strategies seek to beat traditional market cap-weighted benchmarks by using alternative weighting techniques. A simple application of our FVI’s clusters validates the above intuition as the resulting portfolio delivers impressive returns relative to the MSCI ACWI benchmark index as shown in the below chart We provided more detail on the construction and the intuition behind our cluster portfolio in a recent note to clients.
Crucially though, it is the clustering process that does most of the heavy lifting in terms of delivering the superior risk and performance of this strategy. For example, it is easy to show that other smart beta indices, including an agnostically equal-weighted index, also outperform market cap headline indices, but the information, and thus scope for smart diversification, that can be obtained from individual equity- or country-level performance or price metrics is limited. At 11.43% annual returns and 14.4% annualised volatility, our cluster-based experiment easily outperforms even those indices that consider a broad range of factors, such as the MSCI ACWI multi factor (which considers value, momentum, quality and low size factors simultaneously). We believe that by making use of clustering algorithms applied to macroeconomic and financial data, investors can systematically uncover common fundamental traits that can be exploited to improve upon traditional passive investing techniques, we expect this to persist as the growth of passive investment strategies continues unabated.
The charts in this article have been created using Chartbook on Datastream. The Chartbook was initially created by Fathom Consulting in 2012 and is now a catalogue of approximately 9000 charts, covering over 170 countries, analysing up-to-date macro and financial data. Whether it is a particular topic, country or variable you are interested in charting, the Chartbook has everything you need. To access Chartbook via Datastream search ‘cbook’.
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