The good news is that productive capacity has not been affected by the outbreak and should be able to bounce back quickly once demand returns, unlike after other natural disasters such as hurricanes or earthquakes. The bad news is that it may be some time before containment measures are lifted around the world, and in the meantime, markets are reflecting the fact that the economic impact could be significant.
Against this volatile backdrop, defensive and alternative assets are important components in portfolios.
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While it’s fairly easy to hedge against market volatility, it can come at a steep cost if done bluntly. For example, buying near-dated volatility index futures as a hedge all but guarantees strong performance when markets panic, but market participants are aware of this, increasing the price of this insurance.
Additionally, on a buy-and-hold basis, volatility index futures will erode most of your capital within a few years of a bull market. To that end, our teams often consider a more cost-effective strategy that involves buying under-priced volatility through individual stocks and shorting expensive volatility through relevant indices.
This acts as a hedge for when equity markets are rising, and can reduce the opportunity cost of holding this type of insurance during times when market volatility is normal. This strategy has delivered as expected, and is an important building block which we use alongside a suite of other defensive holdings.
These types of volatility hedging strategies are attractive in an era of low rates, as more traditional havens, such as developed market government bonds, offer more limited prospects as shock absorbers given their low yields. Nonetheless, Japanese Yen and gold are often viewed as “safe-haven assets” capable of protecting against risk asset downturns and, in the case of gold, acting as a store of value.
The thesis around gold has three pillars. Firstly, real rates are low which reduces the opportunity cost of holding gold; a non-yielding asset. Secondly, the US dollar has room to weaken further, which is typically a tailwind for gold. Finally, gold’s traditional status as a safe-haven asset in times of market stress has delivered thus far, and looks likely to continue. We access gold through both physical gold ETFs and strategies that invest in gold mining companies. Most of our exposure comes from physical gold to ensure the downside is hedged with as little volatility as possible.
The need for diversification
During volatile markets, leadership can rotate quickly from one sector or market to another. Investors can spread the risk associated with specific markets or sectors by investing into different asset classes to reduce the likelihood of concentrated losses.
For example, holding a mix of ‘risk’ assets (equities, real estate and credit) and defensive assets (government and investment grade bonds, and cash) in your portfolio can help to smooth returns over time.
Actively managed multi-asset funds can be useful as they provide ready-made portfolio diversification. These funds are typically constructed on the basis of strategic long-term asset returns, with asset weights managed tactically according to expected conditions. Spreading investments over different countries can also help to bring down correlations within a portfolio and reduce the impact of market-specific risk.
As volatility looks set to continue in the coming weeks and months, protection in the form of safe haven assets, portfolio diversification and volatility insurance will be increasingly important for investors. As rates remain lower for even longer, securities that can offer sustainable income even under tougher conditions will also become increasingly attractive.
When traditional risk-off positions can become crowded and expensive, looking for more esoteric strategies that profit from increased volatility can be beneficial. But it is important to execute these well given the complicated nature of such strategies and the often-high opportunity costs of holding them.