To The Moon

Stock market decline is an inevitable part of investing. Nevertheless, no one has been able to consistently predict when a bear market will occur. Across market history, there have been many events that have great negative impact on markets. Examples of such events include the 1987 Black Monday crash, 2008 Global Financial crisis, 2011’s 9/11 attack, to name a few. Yet during such periods, the magnitude of drawdown markets experience is not definite. Markets declines can vary widely in intensity, length and frequency and the recovery from trough to peak could take days, months or even years. Unfortunately, as investors, we are unable to accurately pinpoint when we should exit our positions or how long a decline will persist and the truth is, we are likely to go through a few more of such events in our lifespans.

This is also the reason why you often hear many advocate the tenets of diversification. No doubt, diversifying your portfolio can soften the blow of any drawdown stemming from negative surprises, in essence improving one’s portfolio risk adjusted return over the longer-term horizon. However, having a diversified portfolio may not be enough to help you mitigate losses. To provide a better understanding, we take a look at the most recent event in the economic annals, the Covid-19 meltdown.

When the pandemic rippled through global economies, markets was sent into a whipsaw as market participants scramble to de-risk their portfolios from the loss inducing impact the pandemic potentially has on companies and global economies - from peak to trough, the MSCI World index register a loss of more than 30% in a span of 27 days. Amidst such a market terrain, the flight to safety would be to seek shelter in high quality bonds or havens.

Indeed, bonds offers diversification benefits due to the yield cushion they provide. That said, a low interest rate environment today limits the advantage bonds have in a portfolio. Even so, bonds will continue to have a place in investors’ portfolio given that there’s little substitution for high quality fixed income out in the fixed income space. As such, this market landscape has raised a new topic of discussion: is there a better way to protect our portfolios to tide through times of a risk off sentiment.

Volatility strategies explained

Volatility and major market drawdowns have a positive correlation. As gleaned from the chart below, history has proven that volatility always spikes when markets goes into a risk off sentiment simply because market participants rush to exit their positions and inadvertently rock the boat further. Having said that, volatility is not always a bad thing. In fact, investors can capitalise on rising volatility to reduce the downside risk of their portfolios by making use of volatility strategy funds.

Chart 1: Volatility coincides with market drawdowns. Source: Bloomberg

Investing in a volatility fund is akin to paying insurance premium. Similar to your home or personal insurance, these funds provide a pay-out when the proverbial hits the fan, acting as a good diversifier to your portfolio. However, during times where the market environment is benign, long volatility strategies do not perform well since they move inversely with markets. So how do volatility strategies work?

Volatility strategies are negative carry assets which buy into derivative instruments related to equity markets such as VIX index for S&P500 and V2X Index for Stoxx50 Index. These instruments gain in value whenever the VIX or V2X index rises, which happens when the level of risk, fear or stress in the market as implied by options market is high.Therefore, volatility strategy gives investors the potential to gain exposure to a unique asset class that has anti-fragility characteristic built into it.

How does volatility strategies stand out in the macroenvironment

Volatilitywill be the hallmark of the investment world this year in our view. This stems from the change in dovish tone from western central banks to curb elevated inflationary pressures – Feds have wind down their asset purchases and signal for rate hikes to begin in March and the European Central Bank (ECB) is relooking at their monetary policy.

But what really triggered the rise in volatility, we opine, is the uncertainty that comes on the back of the change in policy stance – the Feds left the door open for rate hikes to be more aggressive than expected. Since then, many have forecasted an initial hike of 50bps followed by a series of 25bps hikes. Essentially, the forecasted path of rate hikes spells trouble – faster and greater hikes increase the probability of a shock to asset prices as the market has less time to digest and adjust to the re-pricing of asset values.

Additionally, the speculations that a military conflict will break out between Russia and Ukraine coming to fruition has also resulted in new concerns to surface. Commodity prices have risen significantly thanks to Russia’s decision to escalate geopolitical tensions, adding to inflationary pressures which opens up the question of; will there be a change in policy stance from central banks? – Interest rates are at rock bottom and asset purchases are maxed out which leaves little room for maneuver.

Chart 2: volatility has increase significantly as market participants is met with a slew of news. Source: Bloomberg

Chart 3: Markets had an ugly start to the year with the exception of the energy sector. Source: Bloomberg

With so much uncertainty surrounding the broad market at the current juncture, we think it is worthy to invest some of your monies in volatility strategies to limit downside risks of your portfolio. By investing in volatility strategies like the @Natixis Seeyond Volatility Strategy RA USD-H, the strategy adopted can provide investors with an asymmetric payoff that moves inversely to the market, serving as a natural diversification to one’s portfolio given that markets are likely to be jittery at least for the first half of this year.

Implementing a volatility strategy into your portfolio

Let’s take into assumption that there are three different types of investors. Aggressive, moderately aggressive and conservative investors. How you wish to incorporate a volatility strategy fund into your portfolio really depends on how much ‘insurance’ you wish to take out for your portfolio during a bear market as well as how much relative underperformance you want to undertake during a bull market cycle.

If you are a aggressive investor that invest a large amount of your monies into equities (80/20 equity to bond exposure or more) that generate strong returns during bull market, like the high flying tech sector in the last 2 years, then perhaps having a larger allocation to volatility strategy fund is needed since these equities are susceptible to corrections. In the following section, we will use aportfolio that consist of two different funds as an illustration of how much cushion adding a volatility strategy will provide to the portfolio – an equity fund that invests into S&P500 and a fixed income fund that invests in global fixed income.

Chart 4: Volatility strategies acts as a hedge to your portfolio when markets are turbulent. Source: Bloomberg

Based on the illustration, it is evident that a difference is made when one includes a 15% exposure towards a volatility strategy fund under the fix income sleeve of their portfolio. Yes, this hypothetical scenario we created does not show a huge return outperform with the inclusion of the volatility strategy. in reality, our portfolios includes other securities that is targeted at different geographical locations/sectors and often have differing investment approach or objectives (more specifically mutual funds and ETFs).

As such, during market turbulence, one where we are in now, we believe that having a volatility strategy included in your portfolio will definitely bring about diversification benefits since it acts as a hedge. From the results we have obtained from the basic portfolio we created, we can also conclude that the more aggressive you are as an investor, allocating more towards volatility strategies as a hedge could better protect your portfolio during market drawdown as a mere 15% exposure under the fixed income segment of an aggressive investor portfolio can only provide very little cushion.

Access and invest in funds distributed by Tiger Brokers(SG). Go to the Discover section on the app and slide the top bar to Fund Mall in Tiger Brokers(SG) to explore the full suites of funds we have!