Risk and Reward - Q3 2022

While most investors are open to equity exposure in a low volatility market, they tend to shy away as volatility increases. To counteract equity volatility, asset managers have traditionally added perceived ‘safe haven’ assets like government bonds to the portfolio. But this strategy has been less successful in the current phase of strongly rising bond yields. We suggest an alternative approach that controls equity portfolio volatility without government bonds.
After more than a decade of rising global equity markets and declining bond yields, the last 12 months have marked an inflection point. Persistent inflation, more hawkish central banks and geopolitical uncertainties have prompted an increase in equity market volatility. With that, many investors have begun to rethink their asset allocation.
There have been several volatile phases in recent years – in late 2018 when the trade conflict between the US and China began, in the first half of 2020 when COVID-19 broke out and the current phase resulting from the Russian invasion in Ukraine and the rapid rise in inflation.
The yield on 10-year US Treasuries has climbed from around 1% in 2021 to almost 3.5% in mid-July 2022, leading to heavy losses on the bond markets. At the same time, the MSCI World Index, as a proxy for global equity markets, has declined well over 20% from its all-time high in early 2022. As shown in figure 1, US equities have experienced a very weak first half of the year, and US bonds have had by far their worst first half in at least 32 years. Such parallel losses in bonds and equities are unusual and an indication of significant stagflation fears. Almost the only perceived safe-haven left is cash, which still also yields negative rates in some parts of the world. Investors are thus confronted with a new reality.
Needless to say, such periods are usually exceptionally volatile. Looking at long-term volatility, equities come in at around 16% p.a., with a high degree of variation around the average. But every time equities experience a massive drawdown coinciding with a sharp rise in volatility, investors question their usefulness as a long-term investment and may opt for an exit at the wrong moment. Actively managing portfolio volatility may therefore be a better way to make the daily movements of the portfolio more tolerable and avoid any possibly ill-timed impulse to sell.