Managing increased volatility in global equity markets
Ian Heslop, manager of the Old Mutual Global Equity Absolute Return Fund, notes that levels of volatility and correlations among equity markets have risen together. Market neutral strategies offer an alternative, he says.
How significant is volatility in today’s equity markets?
It’s really significant. What we’ve seen over the last four or five years is a real shift in the volatility of volatility. What that means is that the level of volatility is not as stable as you might expect, and that leads to problems with portfolio construction. There is a direct impact on investment processes, with stocks going in and out of the cycle so quickly. The instability of the market is impacting portfolios both from the perspective of risk management and from the perspective of returns.
What can investors do about it?
One of the things that we try and do is both understand that there are cycles to returns and there are cycles to volatility, and managing volatility has to be done on a reasonably short scale. There’s always a trade-off between responsiveness to market changes and stability at the portfolio level: you don’t want to be overtrading your portfolio. But equally there are ways of bringing in shorter term frequency information, daily information that allows a better understanding as to how volatility is moving through time and managing that change.
What is the correlation of Old Mutual Global Equity Absolute Return to equity markets?
It’s very low. It’s been designed to remain uncorrelated consistently through time. One of the things that I think investors are finding trouble with at the moment is that correlation structures have changed over the past five or six years in line with the volatility profiles. What people really want to see is an uncorrelated return series, because regional equity markets have become highly correlated, with the global macro headwinds impacting regional markets in a very similar ways. Managing the return processes and managing the portfolio construction process to ensure this low correlation through time is something that we’ve achieved, which is going down very well at the moment.
If it’s not correlated to equities is it correlated highly to bonds?
We don’t invest in bonds. It’s a pure equity portfolio. We do obviously monitor our correlation to bonds and the bond correlation is low as well. What the fund offers is another leg to your asset allocation. If done correctly it should give you a return series that is independent of the normal classes you would invest in, bonds, commodities, currencies, equities.
This fund is targeting levels of risk rather than reward, why do it that way round?
One of the things we know most about is risk. Returns are obviously important, but managing the volatility of returns so they are predictable at the portfolio level is one of the most important things you can do as a fund manager. Nobody wants portfolios that you expect to have volatility of four and have volatility of ten. Returns profiles are an expectation rather than a target, just because we know we have a Sharpe Ratio or a risk adjusted return which we would expect to continue. But the thing that we can manage efficiently at the portfolio level is risk.
How does the dynamic valuation strategy work?
That’s one of the things that we talk about a lot, because it comes back to this whole idea that the cyclicality of returns. Value stocks – cheap stocks – outperform expensive stocks through time. But over the short term you can have significant negative returns – when there is a risk off episode, cheap stocks get cheaper. And those losses occur at the same time that the market as a whole is falling. So you get correlation as well. That is a problem if you’re building an absolute return fund which seeks to make positive returns regardless of market direction. We utilise another strategy which measures quality. This helps to break up the correlation and deal with the downside risk of investing in cheap stocks.