Volatile Markets 29.06.2020

This week Chris Fleming of Square Mile answers some of the questions that investors have been asking, particularly at a time when markets have been behaving in roller coaster fashion. Active versus passive management, the importance of asset allocation and why is it so important to diversify a portfolio are all questions that we as advisors have been faced with over the years. Often this is from investors who may have done well from a small number of shares in the past.

ESG – Environmental, Social and Corporate Governance investing as a concept is gaining swift traction, and we expect to be at the forefront of this as it may well be the normal way to invest in future.

Simon Ludden
Managing Director, Tarvos Wealth

In an environment of heightened volatility, which has alarmed relatively inexperienced investors, what themes should they consider to benefit from growth over the medium to longer-term?

Markets continue to be challenging, particularly for those with little experience of such extreme conditions. Market volatility is elevated and sits at levels that are twice as high as normal, although nowhere near where they were at the height of the crisis in March. It is therefore important not to try to be too sophisticated in timing entry or exit points from investments. Many individual investors struggle from ‘regret risk’ and fear missing out on a market high or low. One way to soothe the anxiety that investors might feel in volatile markets is through pound-cost averaging, where money is drip fed into markets over a period of time. 

Much however, depends on an individual’s investment time horizon and the ability to align their capacity for loss with their attitude to risk. This issue is of volatility is of equal importance to us as managers of client portfolios, and the speed with which markets move makes timing tactical asset allocation decisions challenging. It is essential therefore to take a long-term view that goes beyond short-term volatility and to be guided by a strategic overview in making these decisions. 

This leads us to consider, for instance the relative merits of active management versus passive management.  This is a well-worn discussion but investors need to assess whether, in the current environment, they are happy with the allocation profile that an index offers or whether they would prefer to invest with an active manager that has the potential to perhaps dodge those sectors of the market that are somewhat challenged.

We have also been considering technology as a theme. Companies such as Amazon and Facebook have provided excellent returns, despite the elevated valuations of these stocks and technology is going to be increasingly embedded in our lives.

Socially responsible investing is also a theme to which we have been paying much greater attention.

Why is it important to determine the strategic asset allocation of a portfolio in helping clients meet their risk-return objectives?

Strategic asset allocation is a vitally important element. It sets a long-term target and in conjunction with the tactical process provides a risk framework for the overall portfolio construction process – figuratively speaking, it is the North Star that guides investment management process. From a client’s perspective, it is crucial that it is aligned with their attitude to risk and their capacity for loss and to ensure the suitability of their portfolio. 

Why are liquidity and diversification such crucial considerations within a client portfolio in challenging markets?

While strategic asset allocation and tactical allocation frameworks allow quantitative metrics to be put in place, it is more difficult to assess liquidity in such concrete terms. For instance, measures of volatility or maximum drawdown do not give a complete picture of the dynamics at play within bricks and mortar property funds. By these common risk metrics, property funds are typically placed a little higher than bonds but significantly lower than equities, but liquidity can suddenly dry up leaving investors unable to access them – making those quantitative measures wanting. Illiquidity was also a serious problem in March with corporate bonds, emerging market debt and in particular in high yield debt. Many investors tried to raise cash and sell these assets, but as there were far fewer people willing to buy them, liquidity disappeared, and yields increased significantly. here is no accepted approach to managing liquidity risk. Some adviser firms navigate around this risk and are comfortable holding property vehicles. It is nonetheless very important to consider the level of yield that you expect and whether this offset the liquidity risk associated with that particular asset class. We do not believe that investors are adequately compensated in this way for property investments at this time. Indeed, property as an asset class might look very different as we come out of the Covid-19 crisis where there might be less emphasis on city centre office space and more interest in distribution and out-of-town retail parks. 

At all times, it is also important to maintain a qualitative overlay to a fund research process. Over the last 12 months, there have been examples of high-profile funds which have been hit by liquidity issues which would not have been flagged by quantitative screens. 

Are there indications that investor sentiment has turned to favour ESG integrated and responsibly invested strategies?

ESG investing is rapidly evolving. This approach to investment has a long heritage and while initially it was slow to gain traction there is a clear change in sentiment now. There is a great deal more weight behind investing in this way and it is certainly an important consideration for us across our model and advisory portfolios where we are currently seeking to gain access. In time, we believe that ESG considerations will become a fundamental hygiene factor at fund management at all levels. It is also worth touching on the performance of ESG and responsibly invested funds during the recent crisis. These strategies have provided strong returns, in part due to the fact that they are typically underweight fossil fuels, miners and financial stocks which have been hit severely and are less value-oriented. ESG funds also tend to have more of a growth-oriented strategy and show biases towards tech disruptors in the market and industries, such as renewable energy which, while nascent are gathering momentum.

Chris Fleming
Investment Director, Square Mile