Ladies and gentlemen, fasten your seatbelts. Current market volatility is expected to persist. From August to mid-September investors’ near-term expectations of equity volatility, as measured by the Chicago Board Options Exchange Vix index, was over double its average reading of June and July. It breached 40 five times, hitting levels not seen since early 2009.
John O’Toole, Pioneer Investments’ head of multi-asset portfolio management, agrees: “If markets rise you forfeit a bit [on the protection], but you still have structural long equity exposure, so it is a small insurance premium against environments like today’s. It enhances flexibility and improves clients’ risk/reward pay-off.”
BNY Mellon’s Hutchins is another proponent of using derivatives. But, she says: “You have to be clever in finding ways to reduce the cost.”
“In August, for example, the Hang Seng had not fallen nearly as far as the FTSE, and volatility was very low, so it was cheaper to protect your global equity holdings using derivatives off the Hang Seng, than ones off the FTSE.”
But Rothschild’s van der Spek says equity-based derivatives strategies “only protect against falls in the equity market, and do nothing to hedge against falls in the value of bond, commodity, currency or property investment.”
Hutchins says protection can also come more cheaply by buying currencies, for example the Australian dollar, and selling into the ‘safe harbours’ of Switzerland or
Rothschild highlights other alternatives, such as trend following funds which capitalised on the downward movement in markets in 2008, when they made 14%.
This year to mid-September they shed only 0.5%, according to BarclayHedge.
less volatile strategies. For investors wanting to remain exposed to risk assets, but
not face the complexity of options programmes, less volatile strategies that can still benefit from share price rises are recommended – in the case of equities, these include dividend income, convertible bond and event-driven funds.
DWS’s Hille says: “Convertibles combine the chance of participation in the upside of equities, and downside protection of bonds. If the equity markets fall quickly, the
investor gets money back on the bond, but has credit risk.
If markets rise, they can convert into equities to sell at a higher price. If you think there is a good chance of rising equity markets, then convertible funds can be a much better choice.”
Alexandre Pini, portfolio manager at Banque Privée Edmond de Rothschild, says investing in managers betting on market events such as mergers “can give you a much better return than long-only equities, and it is a less risky way to get exposure to the capital markets.”
Risk-averse investors will welcome the news that low risk does not always equal lower returns from equities.
Lazard’s Willumsen says: “You actually can get equity market returns by taking on significantly less risk, you do not have to chase the very ‘compelling growth stock’
stories. Instead, you could invest in high quality defensive companies that have historically performed as well as the market, but with significantly lower risk” in sectors such as tobacco, food and beverage makers.
Michael Fraikin, head of portfolio management, global quantitative equity, at Invesco Global Strategies, explains: “Highly volatile stocks are probably owned by investors who are actually risk-loving and therefore overpay; shorting and therefore market efficiency is more limited for highly volatile stocks; and probably stocks with highly volatile prices also have less robust business models, which tend to fail more often than average.”
MSCI’s Nielsen says: “Growth companies are often loaded with positive expectations because people assume that historical high growth rates will continue for years, but they do not. Similarly, when a company loses 30% in a poor year, people also assume the negative trend will continue. Both these patterns are particularly true for volatile companies. The less risky companies bring fewer
surprises and stable cashflows. The market is neither excited nor disappointed by them. Low volatility strategies are not as exposed to extreme events, so they have
less draw down potential. MSCI introduced the MSCI Minimum Volatility Index in early 2008 for investors seeking lower equity risk.
Willumsen says simple cap-weighted equities benchmarks “are quite risky in themselves, prone to risk concentration whether in financials or TMT, and these concentrations tend to form bubbles which have the potential to spectacularly
blow up, which causes a lot of volatility in the benchmark.”