We live in strange times with little visibility into what lies ahead for the markets in the months to come. Despite Covid-19 plunging every major economy in the world into a downturn for at least one quarter of the year, stock exchanges worldwide and especially in the US have enjoyed an extraordinary recovery, albeit with some recent volatility.
Indeed, the massive collapse we saw in major stock indices – including the Dow, the S&P 500, and the NASDAQ – in the first quarter feels like a lifetime ago. Lifted by the performance of tech titans like Amazon and Apple, the markets have staged a short, sharp recovery that would seem to belie the weak shape of the economy. There is still a pandemic continuing, after all.
Our view is that there remains an asymmetrical balance of risk and reward in the equity market right now. We fear that many investors are underestimating the danger of new waves of the virus leading to further lockdowns and disruption. They may, as such, be vastly overestimating the prospects for a sharp V-shaped economic recovery.
This is compounded by the fact that many of the risks we identified ahead of the coronavirus crisis are still in play – among them, the trade war between China and the US, tensions in Hong Kong, the upcoming US election, and the march towards the finalisation of Brexit. In this context, government stimulus programmes might not be enough to save major economies from prolonged recessions.
Our evaluation of this risk landscape has led us to reconsider the tools that we use to protect our clients’ portfolios. We are, as always, mindful of the dangers of keeping clients out of the markets and losing growth opportunities. But we also believe the risk of downside is significantly higher than it has been for years.
With the scene set, we would like to take you through the tools, philosophies, and methods one can use to protect value in a mature bull market. It’s worth bearing in mind that our risk management approach will vary according to our clients’ investment horizons, risk profiles, and the asset allocations in their current portfolios:
Convert to cash
Cash in a strong currency like US dollars, Swiss francs, or euros is a safe haven in uncertain times. But for most clients, we do not recommend converting their holdings to cash because of the opportunity cost. At this time of low (even zero or negative) interest rates, sitting on cash over longer timeframes leads to the erosion of capital through the effects of inflation.
Diversification is a foundational element of most risk protection strategies. This means defending investors’ portfolios against equity downside by diversifying some of their portfolio into instruments such as cash, bonds, property, or gold, as well as by diversifying the underlying holdings across different countries, sectors, and markets.
Quality is a mainstay of Dynasty’s approach to investment against the backdrop of high stock market valuations and continued volatility. Investing in quality means picking active and passive fund managers who build their portfolios on well-run companies with strong balance sheets, solid cash flow generation, and predictable earnings, regardless of reduced economic activity. Such companies tend to preserve their valuations and perform well in difficult conditions. At this time, we choose to avoid troubled industries and companies that face an uphill battle to recovery during and beyond the pandemic, as well as those where the flight path is less certain.
Portfolio protection insurance
This is a tactic that we are implementing for clients who are already invested in our local and global Proprietary Funds. By purchasing portfolio insurance for the next 12 months, we are able to guard investors against the possibility of a severe market correction. With this sort of insurance, clients are partially protected from a decline of more than 5% in market levels over the next twelve months. The insurance cover is financed through a cap on upside returns of +-11% (in dollars), and 15% (in rand) on global and local markets, respectively over the same period.
We believe this cover on the passively managed elements of our portfolios is appropriate for these times and we will re-evaluate the renewal thereof in a year’s time. Portfolio protection enables clients currently sitting on cash to re-enter equities with a significant hedge against drawdowns on their portfolios. It does mean, however, that they will lose out on some upside if the equities overperform, but we are comfortable with the pay-off profile at the current levels of markets.
Volatility to remain a fact of life
The current volatility in the market is likely to persist for some time, even if there is good news about a vaccine or improved Covid-19 treatments in the next few months. We feel that our process-driven yet flexible approach to managing clients’ portfolios is defendable and enables us to respond with agility to this shifting landscape, enhancing value while protecting against downside risk.