The market environment since the financial crisis has been distorted, with ultra-loose monetary policy, low interest rates and periods of risk aversion aiding passive investing. Fiona Rintoul hears that this is about to change.
We can argue about the reasons why equity markets are becoming more volatile. Tightening monetary policy (now getting looser again). Stuttering global growth. Political nightmares ranging from the US-China trade war to Brexit. All are valid candidates in a mixed picture.
“Clearly interest rates were the catalyst for that first round of volatility last year, but in our opinion not at all the catalyst for volatility most recently,” says Alessio de Longis, multi-asset portfolio manager at OppenheimerFunds.
For de Longis, the primary driver now of volatility is weakening global growth. Political tensions – including the US-China trade war and the rise of populism – are also a concern for some. There is as well an argument that populism is the consequence of a decade of experimental monetary policy. It would be a bleak irony indeed if protectionist policies that the market doesn’t like came into being as a result of central banks’ decade-long support of the global economy.
“There is an argument that benefits of easier policy have accrued to a few percentiles of the electorate and not been widely shared,” says Shrenick Shah, co-manager of the Global Macro Opportunities Fund at JP Morgan Asset Management.
Whatever lies behind the volatility coming back into the market, the question now is one of how to respond. The received wisdom is that volatility is good for active managers and bad for passive managers. Ritu Vohora, investment director at M&G Investments, beats a familiar drum when she argues that volatility, while sometimes unsettling, is not a risk but an opportunity for stock-pickers.
“Market dislocations, when valuations become more attractive, can provide opportunities for long-term investors,” she says. “These are times when active management can prove its worth, generally performing better in the face of change and reversal when selectivity becomes increasingly important.”
The obvious correlation is that this will be to the detriment of passive investing, which has gained equity market share at the expense of active investing over the past decade. The market environment since the financial crisis has been distorted, argues Vohora, with accommodative monetary policy, low interest rates and periods of risk aversion. That is about to change, potentially bringing some rude awakenings.
“In a low-growth environment, investors have been willing to pay over the odds for prospective growth and have been happy to gain exposure to the current bull market cycle via low-cost beta strategies,” she says. “Those stocks are now becoming increasingly more expensive and stretched, and at some point, like an elastic band, could snap back, causing a very painful correction.”
Ouch! That should shake investors out of any complacency they may have slumped into during the decade of low volatility that has just passed. When volatility increases, investors may need to understand better the micro- and macro-fundamentals driving individual securities or sectors, suggests Brooks Ritchey, senior managing director and head of portfolio construction for K2 Advisors, which is part of Franklin Templeton. “Volatility creates vigilance which helps identify valuation differences and oftentimes leads to active alpha opportunities,” he says.
But does this heightened awareness really mean that it’s goodbye passive, hello active? Not quite. Seen from the point of view of a fund selector, the situation looks more nuanced.
“Volatility is an active manager’s friend, but only if it creates intra-asset dispersion,” says Ruli Viljoen, head of manager selection at Morningstar Investment Management Europe.
Viljoen agrees that active managers are expected to show their true colours during periods of price dispersion, but doesn’t think that it’s time to call the end of the passive run. The fee advantage persists – and we’ve all seen the statistics about many active managers failing to outperform after fees, however dispersed prices may become.
“We believe both active and passive funds play a role in fulfilling portfolio objectives,” says Viljoen.
Another way to look at the current situation is to ask: which kinds of companies do well when volatility comes back into the markets? Or, to put it another way: which kinds of companies suffer? If we accept that current equity market volatility is caused at least in part by the unravelling of a decade of ultra-loose monetary policy – or the prospect thereof – then we may fear for highly leveraged companies.
“Low rates strongly support companies with leveraged balance sheets,” says Zak Smerczak, a global portfolio manager at Comgest. “If the debt markets dry up or become more expensive, these companies will fall upon harder times.”
For Smerczak, this provides further justification for the Comgest global strategy’s policy of allocating to self-financing quality stocks with low gearing.
“We feel well positioned going into a period where central banks will provide less support to the markets,” he says. “In our view, a pullback of monetary stimulus should sharpen market focus on fundamentals, which in turn should be beneficial for long-term quality growth stock-pickers such as us.”
For others, this is a moment to focus on the macro-economic situation and to protect portfolios from perceived risks. The market has been concentrating on risks in the US recently, but Florian Ielpo, head of macroeconomic research in Unigestion’s multi-asset team, who sees volatility as a risk for multi-asset managers, believes there should be more focus on the eurozone.
“We expect higher volatility because we see a deteriorating macro situation, especially in Europe,” he says. “We are very much focused on dealing with downside risk in the eurozone.”
How does Unigestion do this? One way is to buy long-term volatility.
“We are buyers of six-month and one-year volatility as a way of protecting against the eurozone downside risk,” says Ielpo. “We think there should also be a comeback of volatility on the currency markets, and we are long V2X versus VIX.”
Regardless of a manager’s buying strategy, volatility indicators such as the VIX (CBOE Volatility Index), MOVE (Merrill Lynch Option Volatility Estimate index), and CVIX (DB Currency Volatility index) may provide a useful bellwether for investors.
They tend to trend lower after periods of heightened volatility and higher after periods of low volatility, observes Ritchey.
“Investors might wish to monitor these indexes so as to adjust portfolios in anticipation of a shift in volatility regime,” he says.
Such a shift may create market entry points for some managers. One of these is Bertrand Cliquet, portfolio manager for the Lazard Global Equity Franchise fund.
The fund aims “to find exceptional businesses but be picky around valuations”. A period of volatility is one situation that might make a fantastic company cheap and bring it up on Cliquet’s purchasing radar – or perhaps trigger an increased investment in an existing holding.
Alternatively, a company might soar during a period of volatility, triggering a sale. For example, Cliquet sold out of Société Bic (best known for its pens) in the fourth quarter after it went up 16%. This is investing for the cold-blooded.
“You have to be extremely disciplined,” says Cliquet. “It’s about being patient and getting it right.”
While Cliquet may be looking for one or two opportunities – the Global Equity Franchise fund is concentrated, investing in between 25 and 50 stocks depending on market conditions – others will seek to capture a range of opportunities when market volatility increases.
For de Longis, the changed conditions mean potential for more relative value opportunities and a nimbler approach. This is particularly true of the US.
“In the US, we’ve come from a ten-year bull run,” he says. “Last year was the first year when the S&P 500 printed a small negative return since 2008. Europe and emerging markets have had much more gyration and idiosyncratic individual performance.”
A nimbler approach doesn’t mean taking on more risk, however. The global multi-asset group at OppenheimerFunds combines long-term structural considerations and valuations, which serve up long-term benchmarks, with responsiveness to the macroeconomic environment. Right now, the group sees a global economic environment that is the weakest in the past five years and expects government bonds, credit and equities to perform much more in line with each other. “Today, we find ourselves with a much more defensive portfolio,” says de Longis. “In this type of economic environment, investors are not really compensated for taking extra risk.”
This perhaps highlights an important distinction between nimbleness and risk-taking. Meanwhile, there is another perhaps counter-cultural view about what increased market volatility means for active equity fund managers, which is that it means nothing.
“It’s a mistaken thing for markets to be fixating about,” says Stuart Dunbar of Baillie Gifford, noting that it hasn’t made the slightest bit of difference to Baillie Gifford’s strategy. For Dunbar, a fixation with market volatility is not just mistaken, it is indicative of a wider malaise in the investment industry.
“A lot of the investment industry has forgotten what investment means,” he says. “If you’re doing your job, it doesn’t have anything to do with share prices. Volatility makes no difference to fundamentals.”
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