Portfolio defences for volatile markets

Will 2019 produce more volatility? Certainly. While that will not necessarily translate into a bear market, the late-cycle US economy, geopolitical uncertainty and spread of inequalities and social tensions all point to rising market instability.

Over the last twelve months, markets have moved violently. Market watchers had a fright in February 2018, and again in the last quarter of the year when the S&P500 fell 19.75% between a late September peak and a Christmas trough. Since then, investors have enjoyed a rebound of 18% and counting.

Investor indicators in this late-cycle economy suggest declining confidence. Although there are no signs yet of a recession in the US, the impact of fiscal stimulus there is fading. In addition, Chinese growth and its imports are slowing, affecting exporters such as Japan, South Korea, Taiwan and Germany, and all of this translates into falling earnings per share.

Nevertheless, we still expect solid global economic expansion in 2019 as many of the risks that materialised last year have declined. The Federal Reserve’s announcement at the end of January that it would pause its interest rate normalisation cycle was broadly interpreted as removing the risk of a US recession triggered by a policy mistake. Markets are now anticipating a positive outcome for many foreseeable geopolitical risks including an extension and/or solution to the 1 March US/China tariff deadline, a fix to the US threat to impose tariffs on European and Japanese automakers and an extension of the 29 March Brexit date. Finally, European parliament elections in late May have the ability to upset markets if voters hand extremist parties roles in the bloc’s legislature.

Cheap volatility insurance

This broadly positive outlook does not exclude more volatility in the months ahead. The first layer of portfolio defence is to reduce exposure to riskier assets gradually, as we have been doing on behalf of clients since June 2018.

The second layer of defence is about volatility. Implied volatility levels, measured by the CBOE Volatility Index (the VIX or so-called ‘fear index’), have more than halved since their December peak. In addition, for the first time in almost a year, implied volatility on the Eurostoxx is now lower than on the S&P500. The result is that it is now relatively cheap to buy some insurance against future volatility.

The goal is to strike a balance between choosing a short-term hedging strategy that offers some defence from a market downturn, without costing too much if the bull market continues. Given the markets’ rallies this year, it makes sense for many investors to buy instruments to offer some shelter for their portfolios should markets turn in the next few months. That would provide insurance for the gains of the first two months of this year.

Cost-effective hedges

Above all, any tools designed to shield a portfolio from a downturn must be cost-effective. Simple hedging strategies can be helpful here, especially if implemented through buying a put, offering investors a form of insurance against a fall in a market or asset.

Depending on an investor’s willingness to pay for insurance and accept downside risk, buying a simple put – offering the possibility to sell an asset at an agreed price before a date set a few months from now – may be appropriate (see chart 1). Concretely, by buying a put on an index with a strike price close to current levels, investors can access a sound shield for their portfolio.

Alternatively, a ‘bear put spread’ involves buying a put option on an index with a strike price, and at the same time selling an equal number of put options at a lower strike price. This lets a less risk-averse investor exercise the put option if the index falls, and then buy back the index at a lower level, making a profit on the difference between the two, minus the price of the option contract (see chart 2).

We believe that the best use of these hedges is in a portfolio’s largest regional equity holdings. Consequently, for a euro balanced mandate we have hedged half of the European equity position, equivalent to one-tenth of a portfolio’s assets, or around one quarter of the global equity exposure.

For instance, buying a 6% out-of-the-money put option (the difference between the option’s strike price and the spot price of the underlying asset) on the Euro Stoxx 50 for 10% of the total equity exposure would cost the portfolio about 22 basis points (bps).

In this example, at the put’s expiry date the position would break even on a market decline of 8.2% and generate a net profit of about 18 bps in the case of a 10% drop, or about 120 bps in the event of a 20% fall. The risk to the strategy is limited to the cost of the premium.

In the uncertain late-cycle environment of a bull market, we believe that the time is right for investors to provide themselves with a cost-effective cushion from 2019’s inevitable equity market volatility.