- Adding a dynamic alpha strategy to diversify market risk concentration can reduce the criticality of judging the optimal timing
- Key among strategies that diversify risk cost-efficiently will be those that employ risk control and downside protection, and that are diversified across many asset classes and markets.
In times like these, it is easy to forget that volatility is a necessary part of a healthy market. In fact, it can be used to reconfigure portfolios to operate more efficiently for the foreseeable future.
The current volatile market conditions started in 2019 amid a trade war, Brexit and a slew of other geopolitical tug-of-wars. These created an opportunity for investors to reassess and diversify.
The US market in particular had become increasingly correlated across asset classes over the last decade. Politics and in particular the US election took over the new cycle, but even in the middle of these catalysts of turbulence, the bull market pushed through like a juggernaut, barely hindered by anything that would typically create at least a moderate pullback.
Then 2020 came and the giant balloon popped. COVID-19 brought with it a wave of volatility that started in China, pushing the CSI300 equity index down in January and again in March.
The wave continued into other parts of Asia and then Europe and the US. Although the US S&P500 equity index has recovered most of what it lost (about 33% from its peak in February), the continuing measures to contain the pandemic mean there will be more volatility.
Volatility can tell us a lot about the state of the market
Yet volatility can be a positive if approached strategically. This is easier to see during bull markets when volatility is benign, but in times where volatility begins to chip away at investment portfolios, this statement can become harder to stomach.
Volatility tells us about the health of the market in several ways:
- It gives us a means of measuring the relationship between those who want to buy the market and those who want to sell it
- It gives us a benchmark for how much we need to spend to protect against large moves in the market
- In addition – most importantly when building a diversified portfolio – volatility provides a way to measure the relative risk across asset classes and markets.
Can volatility be used to time market entrance?
Amid this market turbulence, all portfolios have seen nicks and cracks forming under the stresses of such a rollercoaster ride. As a result, the questions on every investor’s mind are
- Have we hit the bottom?
- How long will the recovery take?
In other words, when is the right time to get into the market? And the answer is: Now, and also yesterday and also tomorrow.
In fact, the real question we should be asking is: “How do I get back in the market?” or “How do I reallocate now?”
First, let’s look at a timing exercise. Exhibit 1 shows the S&P500 during the 2008 Global Financial Crisis. The graph shows three data series, all 90 days before and 90 days after the bottom of the market during the GFC. On the right axis, we have the S&P500 and the VIX during that 180-day period. On the left axis, we have the total cumulative return generated from the start of the day on the x-axis to 9 March 2019 (10 years later +/-1 the offset).
There are two features worthy of note:
- Most of the cumulative returns generated averages of slightly over 200% – meaning it didn’t matter when you invested during that 180-day period if your target return after 10 years was above 200% (about 7% annualised return)
- If our timing of the bottom of the market was off by more than a week, our return potentially dropped by 50%! In fact, we needed to be within one day to hit the 300% mark.
How do we narrow the timing window?
Looking at a chart such as Exhibit 1, one can be tempted to try hitting the bullseye of the timing window. However, in practice, this is extremely difficult as the window is small and difficult to determine.
A better, more efficient solution comes from narrowing the timing window. This in effect corresponds to exchanging the amplitude of the peak for heightened plateaus around the peak (in Exhibit 1) – letting the mountain flatten into the surrounding land, one could say. This can be done in a number of ways, but one of the most effective methods is to add an overlay to the equity position that diversifies market risk.
To illustrate this, we use an overlay strategy composed only of alpha components of the market. Put simply, these components target only the alpha generators of the market that are designed to be less correlated with the broader market. Exhibit 2 shows the strategy's 10-year cumulative return if invested in the 180-day window we saw in Exhibit 1.
Looking outside the ‘bullseye’ window, we can see that by adding the dynamic alpha strategy, we can raise the plateau and make timing less important.
Put simply, this method works because instead of just having one timing window, by diversifying the exposure to market factors (via the alpha strategy), we have effectively put together a series of timing windows that are spread over a longer time.
There is no question that investing in the right asset class at the right time can bring significant gains. However, the margin for error is so small that finding the definitive bottom can either add substantial risk or have the portfolio sitting in limbo for quite some time and thus slowly degrading its value.
So, instead, invest in strategies that diversify the risk cost-efficiently. Key among such strategies will be those that employ risk control and downside protection, as well as being diversified across multiple asset classes and markets.
The decisions that investors make about their portfolios in 2020 will determine their path towards success for the next decade.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.