Multi-assetSep 12 2016

A flexible means of combating volatility

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A flexible means of combating volatility

Global financial markets have experienced a great deal of volatility over the past 12 months as investors have become concerned about a number of headwinds.

It is interesting to observe how quickly attention switches from one topic to the next, but most of the issues concerning investors in the past year or so – slowing growth in China, the prospect of US interest rate rises, political events such as Brexit, and the forthcoming US election – have not really gone away.

Any one of these could re-emerge in the future, or it could be something else entirely.

This uncertainty is a permanent feature of the investment space, and as such it is important to construct portfolios with the flexibility to respond quickly and meaningfully to whatever lies ahead.

Whatever the investment philosophy or process, asset allocation essentially boils down to considering all investment decisions as part of the whole. How does each investment fit with the rest of the portfolio?

It is impossible to know for certain how investors will respond, and therefore how markets will move

What outcomes do you want to achieve, and over what period? How much risk is the portfolio exposed to?

The conventional approach to making these decisions is to start by looking at assets in terms of a sense of the differing levels of risk-return trade-off typically offered by different asset classes.

Many of these assessments of ‘riskiness’ are perfectly logical in theory – investors would probably be more confident in the ability of the US government to pay them back than a company with a low credit rating, for example.

Therefore, US Treasuries would be expected to sit lower on the risk-return spectrum than high-yield corporate bonds. But at certain periods investors have lost more money on US treasuries than they have on high-yield corporate bonds – it depends on the prevailing market environment at any one time.

Expert View: Making sense of volatility

Meike Bliebenicht, senior product specialist for multi-asset at HSBC Global Asset Management, says:

“So far this year we have seen phases of episodic volatility in markets. More often than not volatility is the consequence of an excessively sensitive reaction to adverse news flow. Markets are made up of people and are therefore prone to overreacting or misinterpreting information.

“Making sense of the market environment therefore requires a clear, structured and disciplined analysis of economic risks. It also requires broad asset diversification – holding those government bonds for when riskier assets decline sharply – and ensuring a broad opportunity set to capture the returns of less conventional assets.

“Looking ahead, an environment of low economic growth, low inflation and low developed market interest rates will persist, with important implications for asset markets.

“Specifically, medium-term returns are likely to be low relative to recent history across the major asset classes, and particularly poor for developed market government bonds. Yet the broad environment remains supportive for equities, at least relative to government bonds, and there is still value in high-yield corporate bonds and local currency emerging market debt.

“Being active in asset allocation and being well diversified will continue to be very important.”

The traditional approach to trying to balance the risk and return properties of a portfolio is through diversification. Holding a certain level of risk assets alongside a number of safe assets should, in theory, smooth the journey.

The idea is that these assets compensate for each other at different times, thus delivering a fairly consistent level of return through both risk-on and risk-off market environments.

However, we have only to think about how many times investors have been surprised on either the up or downside in recent years to understand that market movements are not always logical. Experience has shown that risk characteristics are not static.

No single asset can be guaranteed to behave in a particular way in a certain environment. This is explained by the role of human emotion in investors’ decision-making processes.

Conventional financial theory suggests investors are rational and always make objective investment decisions. In fact, studies show that markets move far more than is justified by underlying fundamentals.

This is because investors’ perceptions of risk can change suddenly according to sentiment, rather than simply factual analysis of fundamentals. It is why a ‘set-it-and-forget-it’ approach to asset allocation is unlikely to be successful.

The role of human emotion in driving financial markets and asset pricing means that even if you could predict the outcome of every future event, it is impossible to know for certain how investors will respond, and therefore how markets will move.

As such, allocating assets based on attempts at economic forecasting is unlikely to be successful on a consistent basis.

It is more useful for investors to focus their energies and resources on the one thing they can know – how assets are priced in the context of the current economic environment.

Constructing a carefully considered valuation framework provides a disciplined way of assessing which assets are priced to deliver the best prospective returns. But it is important not to be overly mechanistic about this. The next layer of the process after establishing which assets are attractively valued is to ask, why?

Understanding whether assets are justifiably or unjustifiably cheap is key to defining true risk from volatility. The former represents the chance of permanent capital loss due to a bad investment.

The latter may offer opportunities to those who recognise when markets are moving for non-fundamental reasons, as emotionally driven volatility is usually temporary and can thus be exploited for those with the emotional fortitude to take it on.

Although the global economic environment suggests we should expect volatility to persist for some time, a flexible yet disciplined global multi-asset approach to asset allocation provides the best chance of investors being able to use this volatility to their advantage.

Eric Lonergan is portfolio manager at M&G Investments