How to deal with increasingly volatile markets - IMAP Independent Thought

By Jayson Forrest

When talking about risk, it’s generally referred to in relation to volatility and the potential for capital loss. Raf Choudhury (abrdn), William Higgins (DFS Portfolio Solutions), Glen Foster (Atrium), and Victor Huang (Milliman) discuss their approach to risk and how they deal with portfolio construction in an increasingly volatile environment..

The last 12 months have been a very challenging period for managing multi-asset portfolios. Advisers have had to navigate client portfolios through a range of issues, including  macro economic policies, supply constraints, a global pandemic, and geopolitical problems, which have all had a significant impact on financial markets.

There’s no doubt that with lower liquidity has come greater volatility, but with greater volatility has come the potential for investment opportunities, according to Glen Foster - Head of Risk and Senior Portfolio Manager at Atrium. Despite volatility and uncertainty in the market, Glen believes it is important to focus on risk, even though investor attention may be more concentrated on returns.

Speaking at the IMAP Independent Thought Conference in Melbourne, Glen says advisers need to be mindful that investor returns are essentially backward-looking. Whereas, preparing for risk and positioning for the future is forward-looking, which is definitely an area of advice where advisers can add value to their client relationships.

“Risk is not constant, correlations are not static, and volatility is not persistent. If you ignore this,  what you can end up doing is taking risks that shouldn’t be rewarded,” Glen says. “There are obvious risks that shouldn’t be rewarded. For example, concentration risk, like having too much exposure to equities, doesn’t get rewarded in a risk-adjusted sense.”

Instead, he believes advisers need to have the flexibility to only take on risks where the returns stack up, and also be able to hedge risks when needed. “We take a client’s risk tolerance and then maximise the return for that level of risk, rather than let risk be the outcome of their asset allocation.”

It’s a view shared by William Higgins - Senior Investment Research Analyst at DFS Portfolio Solutions - who believes the biggest challenge to asset allocation and risk management over the last 12 months has been the lack of diversification opportunities for investors.

“Diversification has largely dried up as a result of all asset classes moving together in a downward direction. This has meant investors haven’t even been able to diversify their equity risk with bonds,” he says. “And if you believe that correlations and related behaviours will continue as they have done before, then in this environment, it will only increase the risk you’ll see in your portfolio, compared to the risk we’re seeing in asset classes.”

William believes that with the return of inflation, we’re seeing a dislocation in the way markets traditionally behave, and if that continues into the future, then the amount of uncertainty that is generated will be very difficult to capture in models that have been predicated on what’s happened before.

When faced with increasingly volatile markets, Raf Choudhury - Investment Director, Multi-Asset and Investment Solutions at abrdn - accepts that both advisers and portfolio managers have to think differently about their asset allocation and portfolio construction. However, he concedes that doing this in a managed accounts structure, which are driven by platforms and their investment universe, can be challenging.

“Within the managed accounts space, we are restricted by what we can access. For example, implementing direct futures and options strategies on a platform is quite prohibitive,” Raf says. “However, there are ways to get around this, like investing in other funds that might implement those types of strategies.”

Regardless, Raf believes there are more restrictions with investment strategies within a managed accounts structure, with cost being the key consideration.

“We’re all trying to provide a product and service at a reasonable price, but the more exotic you get by trying to access underlying funds and active managers, the more expensive that can become. So, it becomes a balancing act in terms of trying to design and manage portfolios on a platform for the managed accounts space that are cost efficient for clients.”

Glen agrees advisers can access different types of strategies by investing in a manager that has a long volatility or overlay strategy. However, the problem with that approach, he says, is the manager doesn’t necessarily know what it is the adviser is trying to hedge. Instead, the manager is simply offering a generic strategy for every client.

However, he believes a better way of doing this, which does require some flexibility from the platform, is using access funds.

“We put some of our investments inside an access fund, and within that access fund,   

we can do a put option or we can hedge some of the risk. For example, if it’s an equity vehicle, we can use foreign exchange or equity beta to hedge some of that risk.” 

Milliman has found the managed accounts structure to be flexible to use. According to Victor Huang - Practice Leader at Milliman - the way the business implemented its dynamic futures trading was by setting up its own unit trusts, which just trades derivatives within that unit trust structure.

“Because we can control the allocation within the managed accounts structure about how much a client can invest within those unit trusts, we can very accurately manage the amount of derivative exposure we want in our portfolios within the managed accounts framework,” Victor says.

The unit trust is essentially a small cash holding within the portfolio that provides the risk management, as well as equip clients with leveraged exposure to the risk management that Milliman is trading.

In contrast, DFS Portfolio Solutions was originally set-up to cater to the managed accounts market. So, its investments tend to be in more easily understood assets and structures, like listed securities and managed funds.

“We’re long-only and we don’t use derivatives,” says William. “That tends to mean what we’re investing in is more understandable for clients and through the managed accounts structure, the client has full transparency in what we’re investing in. This transparency does facilitate discussion between the adviser and client, which helps to demystify the investment process for clients.”

Victor concedes that the next 3-6 months is going to be a tough period for investors. He believes volatility will remain elevated, as central banks continue to tighten monetary policy to rein in inflation. Due to this volatility, Milliman has positioned its portfolios more defensively.

However, Victor believes there is light at the end of the tunnel, with the 5-year inflation rate for Australia currently sitting at 2.3 per cent. “We will eventually get to a stage where inflation will be controlled and markets will return to normal. So, from an investor’s perspective, it’s important to stay invested. Advisers need to provide their clients with the confidence to stay invested through this volatile period.”

It’s a similar story at DFS Portfolio Solutions, which is heavily underweight equities. It’s a position DFS will hold until the business sees greater clarity in the type of landing the Federal Reserve engineers to get inflation back under control.

“We are still underweight in duration exposure, although we are starting to increase that as yields have reached a level where you are actually seeing some reward for that duration. We expect that to increase progressively, as central banks get inflation in check,” says William.

And what about credit?

“We are looking at the high quality end of the credit market, and shorter duration. That’s because if we do go into a global recession, we can expect credit spreads to widen, so shorter duration helps us to avoid too much exposure to that type of scenario.”

As for opportunities, William points to pockets in the equity markets, like REITs, where valuations have become very cheap. And while he believes central banks will eventually get a handle on inflation, going forward, he still thinks there are going to be more inflationary pressures that central banks will have to deal with, requiring more direct intervention. 

Glen believes the current market is a great time to be invested. He views this period as being a new investment regime, where business cycles will become more volatile and shorter, but which will also create opportunities for investors.

“I think the market will capitulate and that’s going to provide opportunities,” he says. “So, other than being defensive, I would position my portfolio with a quality diversification of investments. You want to have companies that are resilient to economic shocks and be able to maintain their margins, and the same applies for credit.” 

At abrdn, in terms of scenario analysis going forward, its analysis is heavily consistent with a global recession, which it believes will be led by the U.S. in the second half of 2023. But in the meantime, Raf is expecting more volatility to continue in the market.

This expectation of global recession has influenced abrdn’s decision to go defensive - across both its real return funds and managed accounts.

“In our real return funds, we’ve got about 20 per cent equities, which is perhaps the lowest it’s ever been. There’s a distinct bias within our equities allocation to the Australian equity market and towards quality, as well as specifically targeting markets where we think inflationary pressures are not as heightened, like ASEAN markets,” says Raf.

“Currently, our biggest position in our portfolio is cash - we have 40 per cent, because we do think we’re heading towards an earnings-based recession.”  

Raf Choudhury is Investment Director, Multi-Asset and Investment Solutions at abrdn;

William Higgins is Senior Investment Research Analyst at DFS Portfolio Solutions;

Glen Foster is Head of Risk and Senior Portfolio Manager at Atrium; and

Victor Huang is Practice Leader at Milliman Australia.

They spoke on ‘How to deal with increasingly volatile markets’ at the IMAP Independent Thought Conference - Melbourne.

The session was moderated by Vessela Tasker - Director at Greenwood & Co.