Why managing volatility matters (even for long term investors)

Chances are, this is not the only piece of financial commentary that you read regularly (although if it is, we’re flattered). So by now, having been through months of extraordinary market and geopolitical activity, you may have read plenty of variations on the phrase, “time in the market is more important than timing the market”. It’s a well-worn message, sometimes used to comfort the consumers of financial products and enrich the people that make them. The problem is, it’s not strictly true, even if you’re a long-term investor.

The truth is that shorter term volatility does matter. Ten years ago, we wrote a piece of research that looked at the effect of volatility and spending on multi asset portfolios. As we wrote then, the problem with volatility is twofold; for one, it can rob you of the opportunity to compound capital on the upside, and for another, the impact of the losses is asymmetric to the gains. If you lose 20% in one year you need to make 25% the following year to recoup your losses, and if you’re in the unfortunate position of having lost 50%, then you need to make an eye-watering 100% to get back to square one.

So much for the problem, what of the solution? And, for those that have protected capital this year, what opportunities might we see on the other side of these difficult times? Here, we explore some of the ways in which we’ve been managing volatility, as well as the assets that we have our sights set on to capture the rebound.

While equity and bond markets have certainly offered their fair share of drama in 2022, extreme moves in currencies have been one of the major drivers of investment performance. The most obvious way to manage this risk is to diversify your exposure into other currencies that look cheap. The UK, Europe, China, and Japan all look relatively cheap right now but – crucially – for slightly different reasons, which supports portfolio diversification. Another way to manage currency risk in the longer term is to invest in solid businesses with quality earnings; in the UK there are plenty of good companies with dollar earnings and sterling cost bases, which are still incredibly cheap thanks to the pessimism surrounding UK politics.

Currency volatility has also been a major boon to one particular type of strategy; macro-CTA hedge funds. Interestingly, even though the environment we’re in is clearly providing rich pickings for these kinds of strategies, they’re still not that popular. That may well be because many were poor performers in 2008 (a very different kind of crisis) or because of the lack of visibility you have on the underlying holdings compared to long-only strategies, but with the right levels of due diligence, these can be extremely useful tools in a portfolio, providing alpha as well as diversification.

Options do what they say on the tin in a portfolio: they provide optionality. That’s useful in volatile times for several reasons. Put options allow you to manage your downside risk, as a form of portfolio insurance, while call options give you the opportunity to tap into sporadic market upsides (like bear market bounces) without taking on the additional risk of holding those assets directly. But perhaps their most interesting use right now – when investors are waiting both to see the market reach its depths and to capture the subsequent upside – is that they can provide liquidity when markets tank. That gives you the opportunity to both protect capital, and to deploy it at distressed levels.

The antidote to the pervasive bad news out there is that as assets get cheaper, they also provide the potential for greater returns. Yes, this involves a degree of market timing, but the opportunity set is broad, deep, and driven by several different factors. That means we are unlikely to see a single, linear market rebound; it will happen in stages, across different asset classes. For example, at the moment there are idiosyncratic opportunities to buy quality assets from forced sellers with liabilities to meet; we’re seeing secondary LP stakes trade at 20%, 30% and even 40% discounts. Thinking slightly further ahead, assets like CLOs, private debt and some REITs are reaching attractive valuations as sellers try and shore up liquidity. On a macro level, credit spreads are beginning to look interesting for the first time in years (if not decades), while the distortion between value and growth equity valuations is still extraordinarily wide, even after the weakness of growth equities throughout this year.

There is no denying that investing during turbulent times can be stressful, but careful management of volatility gives you the time, the liquidity, and the emotional resilience to be selective as opportunities arise. Investment markets can be fickle and turbulent, but a solid strategy lets you chart your own course through them. As the late Hilary Mantel rightly pointed out, we needn’t be held to the whims of wider fortune; we have agency even in trying times, and active investors would be remiss not to make the most of it.

As we head into the fourth quarter of the year, the economic and market picture looks particularly fragile. Many - if not most - key economies are on the brink of a recession, inflation is proving stubborn, and the US Federal Reserve has doubled down on its message that bringing down inflation is more important than propping up economic growth.

While the macroeconomic picture is clearly very weak, that doesn’t necessarily equate to a dismal outlook for investors in financial assets, in fact the reverse can be true. When valuations come down, long term projected returns go up. That doesn’t help you if you’ve already been overly exposed to the downside, but it’s extremely helpful if you’ve protected capital well enough to be opportunistic when the time is right. We have protected capital relatively well in 2022, and while we do think that we are very likely to see another leg down in risk assets, we are also looking for signals that the market could start to bounce back. At which point, we would be poised to take on more equity and credit risk, aiming to capture these assets at attractive long-term entry points.

There are perhaps five key events that could materially change market sentiment at the moment: the US Federal Reserve shifting its hawkish stance on inflation, signs of inflation peaking, a reduction in the intensity of the war in Ukraine, the US Dollar weakening and China moving away from its zero covid policy. Any one of these outcomes has the potential to kickstart a shift in sentiment, and we are watching for them closely.

Right now, we think that an asset price recovery is still in our sights, but there will be further volatility and broad market weakness to come before we reach that point. It is also worth bearing in mind that while we have seen precipitous falls in global equities this year, US equities are still not cheap relative to history. For now, we think it prudent to protect capital as we enter what is likely to be an even tougher short-term environment for financial assets. We continue to favour the use of active management and hedge fund strategies, that can take advantage of heightened risk and market dislocation.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.