Over the last 18 months, the Invesco Multi Asset team has maintained that the lack of volatility in several markets versus historical norms was providing interesting investment opportunities. At the start of the year, we published a blog reinforcing our belief that volatility was an undervalued asset class (Investing in Volatility: Is Asian Volatility Poised to Rise?) and specifically addressed Asian equity market volatility and how the region’s fundamentals appeared to be pointing toward a storm on the horizon. In the last several weeks, that storm has blown in — we have not only seen a resurgence of volatility in many equity markets, but we have also, once again, seen signs that yesterday’s playbook with respect to portfolio diversification may not apply in the current market regime.
‘Safe haven’ assets are acting more like equities …
Markets began their tumultuous journey downward toward the end of June, driven by déjà vu worthy headlines around Greek debt and exacerbated by familiar fears over a Chinese slowdown and hard landing. During this period Asian equity markets were particularly hard hit, with the Hang Seng China Enterprises Index (HSCEI) falling 38.5% from its peak in May, for example.
To offset the impact from falling equity markets, investors often look toward “safe haven” assets such as government bonds and exposure to the US dollar, and may also shift their preference to defensive stocks versus cyclicals, and to US markets versus their riskier counterparts. However, most recently we have seen correlations rise between equities and the traditional perceived “safe haven” assets of government bonds and the US dollar, indicating their ability to diversify portfolios during periods of equity market stress is being challenged.
… but volatility may help provide diversification
Historically, volatility has been a strong positive performer in the face of significantly falling equity markets. For this reason, we believe that volatility can be an effective tool for multi-asset portfolios, especially in a market environment where conventional asset allocation wisdom with regards to “safe haven” assets is being challenged.
Recently, we saw Chinese equity volatility, measured using an HSCEI three-month volatility instrument, spike from a relatively benign level in the mid-20s, where it had rested for most of the year, to above 52 at the start of September. This movement was exacerbated by large market players, such as investment banks, quickly becoming buyers of volatility instruments. Those who capitalized on the strong move in Chinese equity volatility were able to help offset the drawdown felt by exposure to Chinese or related equity markets during the sell-off.
Taking a view on volatility
A central tenet of the Invesco Multi Asset investment philosophy is that true diversification comes from an unconstrained approach to asset allocation. This enables us to take a view on the volatility of different markets, and express that view through instruments that allow us to isolate volatility as a distinct asset type. We believe this is invaluable in terms of diversification.
How do we do this? We look for areas where we think that the relative risk implied by markets presents an opportunity. This can be expressed through paired investments in a single asset class—for example, we can express ideas that by design could benefit from an outperformance of Asian equity risk versus US equity risk, and, similarly, by an outperformance of the risk of the Australian dollar versus that of the US dollar. Or, we can look across asset classes. For example, we have ideas designed to capitalize on the relative volatility of UK equities and UK bonds. As with any idea in our portfolio, these volatility ideas are supported by specific macroeconomic themes and fundamentals – the first two ideas referenced above are tied to the China slowdown; the cross-asset UK idea is backed by the potential distortion created by Central Bank monetary policy.
Additionally, we can exploit the diversification qualities of volatility by embedding exposures within an equity-based investment idea. By adding long exposure to the volatility of various equity markets alongside allocations to equities, we believe we can at least partially offset the portfolio’s exposure to a significant equity market drawdown, without meaningfully jeopardizing our ability to capture the upside of a positively trending equity market environment.
It is important to note a few things about investing in volatility instruments:
- While volatility may provide an additional diversification resource to investors, it is by no means a panacea — investors shouldn’t expect volatility instruments to completely replace other diversifying assets. Rather, they may be viewed as a complement due to their distinct qualities in a significant market selloff.
- Additionally, volatility opportunities must be thoroughly evaluated, especially in markets where indiscriminate volatility sellers seeking income may overwhelm normal market dynamics.
- Lastly, sometimes the best way to get attractive exposures to volatility may come from more sophisticated derivative markets that are not accessible directly by all market participants. Therefore, it is important to choose a manager with experience evaluating and trading in these markets.
We encourage investors to talk to their advisors about multi-asset strategies, and to do their homework into the experience of their fund managers. For Invesco Global Targeted Returns Fund, you can start here.
This article was written by Danielle Singer, a Senior Client Portfolio Manager for the Invesco Multi Asset team.