INVESTING IN TIMES OF VOLATILITY

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Financial markets have seen a resurgence in volatility over recent months, amid fears of a global economic downturn, triggered partly by global geo-political concerns, including US-China trade tensions and Brexit.

Keep a long-term perspective

Volatility worries investors because they associate it with rapid (and potentially sustained) falls in asset values but it actually refers to the rate of price moves over time either upwards or downwards. So it presents both potential investment risks and opportunities – that’s why a measured response is vital. Panic-selling in a falling market can lock in losses and may mean missing out on any potential recovery. Likewise, switching investment approaches without fully considering the longer-term implications could make it harder to achieve investment objectives.

Investing through volatile times is not about knee-jerk reactions or second-guessing outcomes to complex issues such as Brexit. It requires a disciplined approach to recognising, quantifying and mitigating different types of risk (including volatility) to different asset classes, such as equities, fixed interest (including government and corporate bonds), and potentially alternative assets such as property or commodities. Expert asset allocation, careful portfolio management, robust governance and maintaining a long-term perspective are critical, particularly in a more volatile environment. 

Return to ‘normal’ volatility

Concerns over volatility have been exacerbated by the fact that it has recently rebounded from historically low levels. Research into S&P 500 volatility, conducted by US money management house Adviser Investment, illustrates this point. The research found that long-term average standard deviation (a measure of volatility) for the S&P 500 from 1957 to 2017 was 15.6%. However, in 2017 it was just 6.7%, the second lowest yearly figure on record after 1963. It therefore seemed noteworthy when it returned to more normal levels in 2018.[1]  

Volatility in US equity indices commonly has a ricochet effect on other global equity markets and can impact bonds too, as has happened recently. So although volatility is an integral part of investing, investors may struggle to adjust to a rebound from historic lows.

Multi-asset approach

Increased volatility could spark greater interest in multi-asset investing, which effectively avoids an investor placing all their ‘eggs’ in one basket. Scottish Widows has a range of well-established, independently risk-rated multi-asset funds that offer a spectrum of potential returns aligned with investment objective and risk tolerance.

Multi-asset investing is not about assembling a random mix of assets and hoping some do better than others. It involves expert assessment of disparate asset types that behave in different ways under various investment conditions – and skilfully combining them in a single fund. The aim is to reduce the impact of volatility by offsetting potential falls in one asset class with potential gains in another. Diverse asset classes rarely perform in identical ways year after year, as factors such as interest rates, inflation or world events tend to impact differently on different asset types. Data on returns from overseas equities, UK equities, UK government bonds, UK property, commodities and cash from 2002 to 2017 show wide variations on a year-by-year basis.

Last year (2018) was unusual, as most major asset classes reported negative total returns with the exception of UK gilts, cash and UK commercial property. According to Schroders, 2018 was only the third year since 1900 that returns from the S&P 500 share index and 10-year US Treasuries were negative in the same year. [2]

Managing funds to reduce volatility impact

Our multi-asset funds are not expected to produce positive returns in all short-term market conditions: broadly, investors in lower-risk-rated funds should experience lower levels of volatility but may potentially see lower long-term growth, while higher-risk-rated funds should expect higher levels of short-term volatility but have the potential for greater long-term growth.

We concentrate on long-term and medium-term asset allocations as the main determinants of our multi-asset fund performance. Our in-house Asset Allocation team are responsible for both these levels of asset allocation; long-term allocation is based on an investment horizon of five to ten years or longer, while the medium-term asset allocation is based on a horizon of 18 months to three years. We remain vigilant to ensure our asset allocation strategy remains appropriate and alert to market moves that can present investment opportunities where an asset class may be significantly undervalued relative to its own history or to other asset classes.

Volatility during income drawdown

Since the introduction of the ‘pension freedoms’ legislation in 2015, the large increase in the number of people choosing income drawdown has brought with it several issues. In order to avoid inflation eroding their pension funds, customers need to remain invested in equities or real assets. However, they also crucially want to avoid seeing their investments fall in value. Drawdown investors do not have the luxury of time to allow their investments to recover from any market falls. This is compounded by ‘sequence of returns’ risk, where a drop in value in the early years of drawdown can significantly reduce the length of time that an individual’s pension fund will last.

In response to this issue, in 2018, we launched our Retirement Portfolio Funds, which employ an innovative approach to dealing with volatility during income drawdown. The four funds invest in a mix of equities and corporate bonds, each with a different strategic asset allocation according to its risk rating. In times of high volatility, the equity component of the funds is reduced to limit the impact of any market falls. To achieve this, the funds use an automated process called Dynamic Volatility Management (DVM).

DVM uses an algorithm to respond to equity market volatility. When volatility is within defined levels, the funds are invested according to their stated asset allocation. However, when volatility exceeds that level, the funds reduce their allocation to equities. The DVM threshold is dynamic and moves depending on equity performance over the previous 12 months. If equity markets have been rising, then the DVM threshold will be moved up (as customers can tolerate more volatility after a period of growth). In falling markets, the threshold will be revised downwards so the funds will de-risk earlier.

In summary, volatility is an inevitable part of investing in markets, and our multi-asset pension funds are designed with this in mind. Further, for those customers invested in our Retirement Portfolio Funds, we offer our unique Dynamic Volatility Management.

We deliberately invest for the long-term, believing that it would be to our customers’ detriment should we try and predict short-term moves in markets. However, we are always alert to pricing anomalies that may result from volatility, and will look to take advantage of these when we deem them to be sufficiently significant.  

As part of our robust governance framework, all of our investments are reviewed on a regular basis. In the current investment environment, we strongly believe that customers invested in multi-asset funds that meet their tolerance for investment risk should not be diverted from their long-term goals by short-term volatility spikes.

Sources:
[1] Adviser Investment research, Forbes.com, December 2018
[2] Schroders Global Market Perspective Economic and Asset Allocation Views Q2 2019

Other articles in this edition

THE BENEFITS OF TAKING A LONG-TERM APPROACH TO INVESTING

Setting a realistic timescale for investing is one of the crucial decisions to make when considering whether to save or invest.

“VALUE FOR MONEY” IN PENSION FUND CHARGES

The change in focus from regulators is an acknowledgement that assessing quality in a pension scheme is about more than just cost.

FOCUS ON A FUND MANAGER: Q&A WITH NEWTON’S TIM WILSON AND BHAVIN SHAH

Launched twenty years ago, the Newton Managed Fund is one of the longest-running and largest funds in the Scottish Widows range.

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