Equity markets may have had a better run at the end of October but the summer months were painful for many.
The areas that have protected capital over the past six months have been both predictable, such as gilts, investment-grade corporate bonds and global bonds, and surprising – Japanese smaller companies, for example. However, just as insurance is always more expensive after an accident, investors are now paying a lot of money to protect their portfolios through these asset classes.
All these traditionally low-volatility asset classes have been equally volatile, even if they have ultimately proved profitable. Is there a solution for investors seeking some protection for their wind-swept portfolios?
Whitechurch investment director Gavin Haynes says the conventional approach of balancing stockmarket exposure with gilts may continue to offer protection. He says: “These two asset classes have tended to work in opposite directions. The rewards in gilts are not compelling but if you believe the doom and gloom scenario, this would be the place to sit.” He points out that the UK’s austerity measures have firmed up the country’s finances and the risk of default is now minimal. S&P has recently reaffirmed the UK’s AAA rating.
But Thames River Capital joint head of multi-manager Gary Potter says part of the problem is that the correlation of most major markets has been high, which has rendered some conventional hedging techniques obsolete. He says: “The focus on this area has exploded with the growth of multi-asset funds. It used to be that if you did not like an asset you did not hold it and simply held cash instead but now there is a desire to make it more complex. We have tended to keep it relatively simple. If we don’t like equities, then we hold cash or sell index futures to bring down the overall equity exposure.”
Saltus partner Dan Kemp says the see-saw approach, where an investor switches between defensive assets and riskier assets depending on his view of the environment, is still an option. It has been used successfully by investors such as Jonathan Ruffer but Kemp adds: “The problem at the moment is that fear assets have become very expensive and therefore the see-saw is broken. If you have to overpay for these assets, the risk increases.”
On the basis that conventional measures to mitigate volatility are less compelling, particularly if the climate improves, Haynes believes the absolute return sector may also hold some solutions. Overall, the sector has dipped by 1.9 per cent over the past six months. It may not be the promised absolute return but it is better than the UK all companies sector performance, where the average fund has dropped by 7.8 per cent.
A number of funds did well during the market volatility, notably those from Kames, Liontrust, BlackRock and Cazenove. Haynes gives the example of Philip Gibbs, whose Jupiter absolute return fund has tended to provide a bulwark against falling markets. Gibbs is notoriously bearish and has positioned his portfolio to benefit from a weakening economic climate. The fund has been weak as markets have risen but has proved its worth in the recent market rout.
Investors could also hedge volatility through the derivatives market but this has some drawbacks. The options market is extremely volatile and, for the most part, very expensive. Kemp says: “If you buy too late, you pay too much.” In other words, investors need to hedge their portfolios when risk levels look relatively low, which is not an easy trick.
Potter agrees that, in all cases, investors need to be careful what they pay for protection against volatility because it can prove very expensive while Kemp suggests volatility in itself may not be the problem. He says: “No one really worries about volatility if it means big gains. They only worry is if they are losing money in a hurry.”
He shares Potter’s opinion that to mitigate sharp pullbacks in the market, the first option for many people would be to hold higher levels of cash. “If you are an investor rather than a short term trader, time is on your side. The Keynesian quote that says the market can stay irrational longer than you can stay solvent generally only applies to over-leveraged investors. Those with cash have a buffer.”
Vertem Asset Management branch principal John Dance says buying an ETF on the Volatility index, the Vix, should provide the perfect hedge against volatility, in theory. They are available, although the main ones are listed in the US. The ETF should go up when volatility rises and therefore make the investor money, compensating for any losses in his main portfolio. Dance says quirks in the pricing of these ETFs mean they have not served as a perfect hedge in the past and tracking error has been significant.
Dance believes an investor’s only real option in the current environment is cash. He says: “Currencies, sovereign bonds and gold have all proved extremely volatile, therefore they do not work to defend a portfolio.”
There is no easy solution to market volatility. Markets have been subject to significant manipulation over the past four years, largely through government invention such as quantitative easing. The increasing politicisation of markets has thrown out conventional analysis. The only truly reliable solutions for investors are cash or patience.