When the going gets tough, it can be tempting to run to cash but, argues Trevor Greetham, volatility cuts both ways and there is good money to be made from going against the herd from time to time
Last year marked the start of a new higher volatility regime and this has major implications for portfolio construction. Spreading investments across a broad range of asset classes reduces risk but active tactical asset allocation and volatility management can also play a vital role in reducing losses when markets are turbulent.
Concerns over rising US interest rates and trade wars led to some incredible price swings over 2018, capped off with Wall Street experiencing its worst December since 1931.
US equities returned to their previous highs over the first few months of 2019 as the Fed shifted to a more patient stance and tariff increases were postponed.
As the recent sell-off goes to show, though, it does not take much for volatility to return when it is late in the business cycle and geopolitical risk is high.
As of June 2019, this will be the longest US economic expansion since the 1850s but recession risks are starting to emerge. Monetary policy works with a lag and two years of steady interest rate rises are beginning to take their toll on the US housing market.
The same time lag explains why, as Chart 1 shows, equity market volatility tends to trend higher about two years into a monetary tightening cycle.
With the US economy slowing and past rate hikes still to take full effect, now is a good time to think about client portfolios' resilience to shocks.
Tactical asset allocation can help investors to preserve capital and generate additional return when economic conditions deteriorate. Different asset classes tend to do well at different times.
As Chart 2 illustrates, our own 'Investment Clock' approach makes an explicit link between the behaviour of financial markets and the global business cycle.
We are always on the look-out for conditions that could be unfavourable for stocks. Last year, for example, saw a steady move into the 'stagflation' phase of the cycle.
A slowdown in global growth caused analysts to slash their corporate earnings forecasts while rising inflation meant the Fed and other central banks continued to hike rates.
Equity markets have often generated losses when faced with this double whammy of bad news and we reduced positions over the summer, limiting losses when stockmarkets took a dive.
Active strategies can help investors weather volatile environments and enhance returns.
As an example, we bought stocks back at lower prices last October and again in December when we judged that investors were excessively concerned about the global growth outlook.
History shows it often pays to buy when markets are fearful. We use a proprietary sentiment indicator - see Chart 3 - to identify moments of panic when a contrarian approach is likely to pay off.
For some investors it may make sense to take a more direct approach, reducing exposure to equities systematically during periods of extended market turbulence in order to limit the potential for loss.
As Chart 4 illustrates, equity markets post their best returns when volatility is low and generate their worst peak to trough losses when volatility is high.
Since 1973, the average peak-to-trough loss for US equities when volatility was below its long-run average was generally in the single-digit percentage points.
As Chart 5 shows, however, during periods of above-average volatility, the market experienced losses of 50% on more than one occasion. Strategies that scale back equity market exposure to cap volatility can reduce losses at these times.
A common criticism of volatility managed strategies is that they reduce exposure to stocks after a correction, leaving investors locked in cash when markets recover. For this reason, we see value in combining volatility management with an active tactical asset allocation overlay.
The approach we follow makes use of two complementary sources of return. Risk premium strategies are designed to add value during positive market trends and can be accessed through a core portfolio diversified across a range of liquid assets.
Tactical asset allocation strategies are best implemented as an overlay and seek to add value irrespective of market direction.
We manage downside risk in the core portfolio by reducing equity exposure when we expect volatility to breach an acceptable level. Importantly, tactical asset allocation operates within its own risk budget.
This means we are free to exploit short-term opportunities irrespective of the volatility backdrop. We simulated the returns of these strategies since the mid-1990s and found the two sources of return to be highly complementary, as Chart 6 illustrates.
Volatility managed risk premium strategies captured a good portion of the upside during calendar quarters when stocks rose but experienced much smaller losses when stocks fell as the volatility cap was more likely to be in force at these times.
The simulated impact of tactical asset allocation was positive on average, regardless of market direction, but tended to be higher in down markets - a result confirmed by our experience in the last financial crisis.
Combining these strategies led to an attractive return profile, capturing about half of the upside in bull market trends but moving broadly sideways in bear markets.
It has been almost a decade since the last recession and memories are short. There can be a temptation to make a 'dash for cash' when the going gets tough but volatility cuts both ways and there is good money to be made from going against the herd from time to time.
For long-term investors who care about short-term losses, we would advocate a multi-asset approach that manages volatility levels while preserving the flexibility to take advantage of the many tactical opportunities that will arise when uncertainty is high.
Trevor Greetham is head of multi-asset at Royal London Asset Management
This article first appeared in the June issue of Professional Adviser's sister title Multi-Asset Review, which is now out. To make sure you receive your own copy of the next issue, please do register your interest here
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