Navigating financial markets - Airbag your portfolio
Markets tend to be kind to those that stay invested over the longer term, and this year has been especially kind – at least so far. This holds true not only for equities, but also for fixed income markets. Our general view of markets is to remain invested for the time being, however, protecting the good performance since the beginning of the year could turn out to be a good idea.
Volatility on financial markets has been relatively low in 2019. In benign markets, as we have seen since the beginning of 2019, overall volatility, a common risk barometer, tends to be low. In fact, when comparing to historical levels, volatility is currently relatively low, not only in equity markets, but also in fixed income and currency markets. Yet, history tells us that volatility in financial markets tends to be mean reverting over time. This means that volatility usually returns to a long-term average. In other words, volatility, like the tide, tends to come and go in cycles. However, while the timing and amplitude of the tides in the oceans can be forecast quite accurately using science, predicting changes in volatility is as much an art as it is science. As with all art, while we may all be looking at the same object, we all see something different.
Tail risks have grown over the past months
With this background in mind, we can see a number of tail risks on the horizon that could make markets less benign and drive volatility higher. Factors currently of concern include the continued China/US trade quarrels; the Iran oil situation; the homemade problems of the German car industry; Brexit; and any possible shutdown of the government in the US because of debt ceiling issues in the autumn. Last but not least, there is also a risk of central banks making policy mistakes as they have to take the impact of geopolitical events into account when formulating monetary policy.
The case for an ‘airbag’ for your portfolio
We continue to propagate investments that benefit from a broadening of global growth. However, investors could also consider applying an automotive analogy to their portfolio, ‘drive with an airbag’ to smooth the adverse impact of a potentially more turbulent environment. In this context, it may be a good time now to consider protecting gains or at least reducing the downside risk to the portfolio in order to smooth the impact of potentially rising volatility.
In investment terms, this means that investors could consider strategies that benefit from higher volatility (‘tactical asset allocation’), but should also take a look at whether their investment portfolio reflects their longer term investment objectives (‘strategic asset allocation’).
Consider the big picture – strategic asset allocation
While the exact figure is debatable, it is widely believed that at least 80% of portfolio returns can be attributed to asset allocation. Hence, determining what proportion of one’s wealth should be invested into each asset class is crucial. Through diversification, an investor can reduce risk by not being overly exposed to a single asset class or security. As a result, the overall portfolio return is likely to be less volatile. This holds true for a low volatility environment, but even more so when volatility is high. In short, asset allocation matters. For further information, please see the related article on this website.
Convertible bonds embrace volatility – tactical asset allocation
Investors looking to be invested in the markets but wanting some sort of cushion against higher volatility could consider convertible bonds. They offer the potential for high upside participation in equities with limited downside risk. They can also be attractive from a portfolio diversification perspective.
Specifically, convertible bonds have achieved nearly 80% of the return generated by equities with only 60% of the volatility over the last ten years. Thus, as the correlation of convertible bond returns to equities is nearly 90% (i.e. they move up and down almost in tandem), convertible bonds can also be considered as an attractive alternative to equities given their superior risk-adjusted returns. Relative to corporate bonds, convertible bonds have also performed well – generating returns nearly 70% higher but with ‘only’ 40% greater risk (volatility). From a portfolio perspective, as the correlation of convertible bond returns to corporate bonds is nearly 60%, adding convertible bonds to a portfolio of corporate bonds can help increase returns with limited additional risk.
Convertible bonds have achieved nearly 80% of the return generated by equities with only 60% of the risk over the last ten years.
From an investor’s perspective, convertible bonds are fixed-income instruments as they have a fixed maturity, fixed repayment amount and fixed interest payment. Thus, these features offer investors fixed-income like downside protection. However, unlike in the case of traditional bonds, convertible bonds can be converted (hence the name!) into a fixed number of equities (usually of the same issuer) at any time.
When volatility in the underlying equity rises, this right to convert into shares becomes more valuable and thus tends to support the price of the convertible bond. This is because the probability rises that the stock will have greater moves and thus it becomes more interesting for the investor to convert the bond into shares. However, as convertible bonds have equity- and bond-like features, the associated risks need to be taken into consideration.