In times like this, asset allocation makes an outsized impact on your overall returns. An investor with a portfolio of stocks that have outperformed equity markets is likely to still be facing significant losses, but those who were carrying conservative allocations when the volatility struck have held up much better.
“A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies.” – Harry Markowitz
Raf Choudhury is a Senior Portfolio Manager at State Street Global Advisors, who manage more than $3T of assets for clients globally. His primary focus is tactical asset allocation, absolute return, and equity risk reduction strategies. With so much volatility in equity markets right now, I reached out to Raf with a series of questions about investing through these conditions.
How were you positioned at the start of the year?
At the start of the year we still maintained a healthy exposure to risk assets. Our views at the start of the year were based on our outlook around market fundamentals. The time frame for those to be realised is now clearly extended. In our Global Market Outlook at the start of the year, we had highlighted that the stellar equity market returns of 2019 had been based on multiple expansions. Earnings were going to be key this year to sustain equity market growth – although we were expecting 2020 to provide single digit market returns. The beginning of the earnings season had shown some promise, markets through the start of the year had continued to rally.
It has taken (two) black swan events to turn markets on their heads. Earnings are now being revised downwards and while the overall downward trend is likely to continue for a while yet, with current market volatility expect markets to under and overshoot on a day to day basis.
How are you positioned now?
At the heart of the current market turmoil are two black swan events – the global pandemic brought about by the spread across the world of COVID-19, and an unprecedented collapse in oil prices. This two-punch combo has the global economy reeling and has sent financial markets into crises mode. Monetary and fiscal stimulus are just band aids that look to buy time and offset some of the short/medium term drag on growth.
In the meantime, we have seen a strong wave of risk off sentiment as risk asset sell off and the spreads on fixed income assets widen reflecting the lack of desire to take on risk. Our proprietary indicator of market risk sentiment (the Market Risk Indictor or “MRI”) started flashing high levels of risk aversion before the end of February but had been signalling that markets had become over exuberant in January. Maybe overlooking the potential impact of COVID-19, which at the time had been limited to China.
In the State Street Multi-Asset Builder Fund, we started to reduce risk assets in mid-January. We continued to further cut risk assets through February as the global contagion and impact became more evident. Risk assets have moved into bear market territory with equity markets having been at record highs only a few months ago. Investor risk aversion is at levels seen through the GFC as uncertainty lingers around the future path of this pandemic. In response many central banks have cut interest rates to record lows. Additionally, liquidity being pumped into the system and vast programs of fiscal support have been announced.
Have you taken out any specific hedges in light of recent volatility?
With the broad market sell off that we have seen there has been few areas that have managed to remain unscathed, but more defensive and less cyclical sectors have shown some relative resilience.
- We have cut risk asset exposure and added specific tail risk hedges to our portfolio.
- Where we are holding risk assets and equities, we prefer more defensive styles of equities that should help limit some of the drawdowns.
- Specifically targeting the long end of the curve where yields are a little higher and so have a bit more room to move.
- Focusing on diversification, we also have a managed futures strategy exposure that is held for these exact kinds of environments.
Which asset classes or regions do you consider a "sell"?
It’s easy to let fear take hold and think about selling equities but investors should be cautious about making solely emotionally driven decisions. For every person talking about selling in this market there is someone who will view it as a great buying opportunity. We are a little more cautious in the short term but are fortunate that we have a process to assess market risks and guide our positioning. We are currently underweight risk assets but are prepared to quickly re-enter positions.
From a regional perspective the area we are less constructive on is Europe. We have already seen them slow to implement containment measures and given the fragmented nature of Europe as a whole, they may find cross border containment harder to manage. With an already weak outlook, these recent events provide even less support for the region.
Which asset classes or regions do you consider a "buy"?
Those that were concerned about valuations might consider this a buying opportunity but should think about this as a long-term trade. Certain sectors have also held up, most notably health care and consumer staples as the pandemic is expected to increase demand for products and services out of these two sectors. Non-cyclical sectors such as these along with utilities should see less impact on earnings growth as well. While maintaining some equity exposure, being more selective in styles and sectors is key. In the current environment investors should select more defensive style equities.
In addition, investors should think about tactical hedges such as gold and long duration fixed income. For low risk investors who would normally be looking at term deposits and traditional fixed income, floating rate notes can provide a spread pick up in an environment where cash rates are nearing zero and yields across fixed income are at record lows.
What signals will you look for before increasing risk levels?
Now might not be the right time to try to catch the falling knife. It makes sense to wait a bit. Market volatility will continue even when at some stage markets rebound. However, the volatility we are seeing is reflective of how fragile markets are. The fact that they are trading off news stories means that we could see extended periods of day to day reversals.
To get back into growth assets we are looking for catalysts that could signal buying opportunities including a change in investor sentiment. That is most likely going to be driven by changes in the narrative we are seeing in the press. Central banks and governments are doing their bit to provide short term support, but those measures don’t cure COVID-19.
One signal we are looking at is the rate of spread, while we expect this to increase in the US, a key metric to keep an eye out for will be the rate relative to what we have seen in other countries thus far. Also, how long before governments start to loosen some of the measures they’re putting in place to manage containment? This will be a sign that things are improving.
What are some traps to avoid for nervous investors?
Lots of investors will be reminded of the GFC, but for me there is one key lesson they should remember from that experience. That is that being out of the market is as big a risk as staying invested. Lots of investors sold at the bottom and didn’t buy back in until much later, compounding their pain.
While we have a process that helps us gauge the current risk environment and inform our decision on how much and how to invest, most investors don’t. They should remember that they typically have a long-time horizon and that diversified portfolios are designed for such markets. They might incur some loss in the short run, but they should keep focused on their long term objective.
Every portfolio needs a solid foundation.
The evolving market backdrop creates plenty of opportunities and challenges for investors. To learn more about State Street's Multi Asset capabilities, watch Livewire's Fund in Focus here.
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Great insights, Patrick! Big fan of your podcast
Excellent interview Pat and some great messages from Raf.