It is always worrying to hear investors ask how managers performed over very short time horizons. It seems very unlikely that a couple of weeks’ performance can tell you much about a fund manager’s skill as opposed to luck.
But short time frames might be able to tell you something about the prevailing environment, and potentially which strategies may be suited to it. February was certainly interesting in this respect, with two observations worth making:
Did an industry obsession with volatility intensify the equity moves we saw in February? There are two elements to the argument that it did:
- the direct impact of volatility becoming a tradable asset in its own right
- the widespread conflation of volatility with risk.
The first of these is more recent and captured headlines due to the possible role played by forced liquidation of short volatility products in broader market moves. In reality though, the extent to which such products truly impact the underlying stocks is hard to establish.
The second is nothing new but arguably more significant.
The human tendency to over-emphasise the short term is as old as markets. However, as Eric wrote a few weeks ago, this human tendency is being compounded by a shared conception of volatility as risk prompting correlated investor behaviour: adding to positions simply because volatility has been low, or selling because it has been high.
Hopefully most of us are now aware that volatility is not risk, even if many parts of the financial industry seem to go ahead and conflate the two anyway. Indeed, our team’s belief is that volatility is often a source of opportunity; episodes are often created because human beings become myopic.
It should therefore be encouraging for active long term strategies if this type of behavioural error is being hard-wired into quantitative risk models and passive investment structures. By contrast, strategies constrained by standard risk models or stop losses may be unable to exploit such opportunities as they emerge.
Hedging cyclical risk versus hedging valuation risk
If volatility isn’t real risk, what is? Most simplistically, investment risk is the chance of not meeting your return targets when you come to redeem. And the forces that drive this haven’t changed.
- the cash flows you expected from your investment can’t be delivered (think earnings recession, bankruptcy, or default),
- you were wrong about how much you could actually buy with those cash flows and/or the principal (inflation), or,
- when you come to sell the asset, you don’t receive as much as you’d hoped, even in real terms.
Almost all investment risk is a combination of these three elements. The first two risks could be considered ‘fundamental’ or ‘cyclical’ risks; they are related to the state of the economy, government, or company you are investing in. The third risk, the price at which you sell, is usually the most important (especially as you shorten your time horizon) and is often a function of the first two fundamental forces.
However it is possible to be subject to the third risk without earnings, default, or inflation risk playing a role. Sometimes it may just be that you purchased the asset at the wrong price; this is ‘valuation risk.’
Valuation risk can arise because other investment prospects are seen as more attractive. If interest rates have gone up, it may be possible to secure a government bond offering the same real return as the asset you hold. This dynamic can mean that hedging valuation risk involves a very different approach to hedging other risks.
For much of the last decade investors have been principally concerned about hedging ‘fundamental risk,’ and growth in particular. Developed market government bonds can be a good hedge against these risks because they should be less sensitive to growth dynamics.
More recently, strong data have meant that there is greater comfort with the state of the world economy (albeit with growing consensus that we are ‘late cycle’). In February investors seem more concerned about valuation risk; the notion that we are facing the end of the ‘everything’ bubble.
This is one reason why rising interest rates have become a source of volatility once more. For much of the last twenty years, an increase in volatility has been associated with strong returns from US Treasuries (see figure 1 below). However in February, this traditional source of diversification was not available, because rising rate expectations were the source of volatility.
The best way to hedge valuation risk over longer time frames is clearly to buy assets that you feel are attractive in their own right and which offer a margin of safety. However, when there is uncertainty about the long term risk free rate, on which all assets depend, managing short term volatility may require non-traditional sources of diversification.
Tony wrote at the beginning of last year about how multi asset strategies would need to be more active in the period ahead. February illustrated that not only are some traditional sources of diversification offering low returns from here, but are also potentially adding risk to portfolios in certain conditions.
With rising yields on US Treasuries, these traditional sources may once again become a compelling source of protection against growth risk. But, in phases in which valuation risk is driving markets, avoiding (or shorting) areas that have been clearly geared to a falling rate environment and looking for diversification by sector, geography and active currency management could be increasingly important.