We didn’t know February 5 would be the day. No one did. But for the past year, we’ve espoused the benefits of managing risk, moreso than taking risk.
On that day, the Dow Jones Industrial Average plunged 1,175 points,1 marking an exceptionally volatile day for financial markets around the world. The 4.6% drop was the biggest decline since August 2011, and caught many market participants by surprise.
Our stance spoke to the valuations within markets as well as low starting yields in bonds, but was also driven by what we saw as a more seminal aspect to managing risk. In a previous blog post, we discussed that protecting against the downside in markets just may get you more bang for your buck. While the power of compounding through losing less on the downside is relatively easy to understand in theory, to execute that strategy means being willing to reduce risk as markets move higher than your expectations—and doing so in a robust way. Put another way, the time to prepare for a perfect storm is not when the wind is tearing the roof off your house, but before the storm hits.
So how do you prepare. We’re a multi-asset shop, so we may be biased. But we take our approach because we believe it’s ideally suited for our uncertain times.
While the objectives of multi-asset strategies may vary, our portfolio management team talks a lot about giving clients the returns they require at a risk level they can survive. A multi-asset approach may help achieve these goals through three main processes: 1) The design process, where we establish strategic positioning; 2) The construct process, where manager selection and strategic factor positioning takes place; and 3) The manage process, where tactical tilts, through dynamic management, help exploit near-term opportunities and avoid uncompensated risks.
I’d like to focus on the manage process. Dynamic asset allocation can include managing a portfolio of physical securities, such as stocks or bonds, or implementing overlay-based strategies—including, but not limited to, options, currency forwards and futures. And dynamic is the key word right now, because we believe nimbleness and dynamism is most beneficial during periods of market dislocation, where the elapsed time between idea and implementation is critical. Because, as February 5 reminds us, markets don’t work on quarterly cycles.
Another case in point: In 2017, our multi-asset portfolios were defensively positioned with significant equity replacement strategies within the U.S. equity space. This equity replacement position is complex, so let me break this down into four steps:
- The position meant a short in U.S. equity futures, while simultaneously buying call options to give the portfolios upside.
- Because volatility had been so low, costs for this option were small (relative to history) before this week.
- This allowed our portfolios to trade well in the up-market through January 2018, as those call options moved well in-the-money.
- Since those call options moved in such a profitable manner—and given the remarkably low volatility at the time—we decided, at the end of January, to roll the existing options into new positions at a much higher level, locking in the gains and adding further market downside protection.
Simply put, the rolling of the options decreased our overall equity exposure and increased our liquidity. In hindsight, this has clearly been a fortunately timed move, helping to protect our portfolios when markets subsequently sold off earlier this week.
After raising liquidity, we are now in the fortunate position of being armed with cash to deploy through options, futures or our active managers across multi-asset portfolios. We like being in this position, as a liquidity provider—buying when others choose (or are forced) to sell. We began this process with markets down nearly 7% this week, cautiously deploying some of the cash position and adding a bit of risk back to the portfolios in emerging markets. This move was small, and perspective here is warranted, because the sell-off has only removed a small degree of the overvaluation in markets. They are, after all, only back to levels we saw in December 2017.
As recent events show, the ever-evolving manage process of our multi-asset investing approach enables us to prepare our portfolios for uncertain markets—and dynamically adjust as the cycle, valuation and sentiment in markets evolve. If the recent uptick in volatility is a sign of things to come, we believe that having this dynamic ability will continue to prove essential going forward. Because another correction day will come. And no one knows when.
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.
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