David Elms, Head of Diversified Alternatives, and Steve Cain, Portfolio Manager, give a mid-year update of their market outlook, considering the impact of the COVID-19 crisis on investment markets, and outlining the potential risks and opportunities they see for alternative strategies for the remainder of 2020.
- It looked like markets were underappreciating and under-pricing risk at the start of 2020, as evidenced by the levels of the CBOE VIX Index. There was danger that any significant exogenous event could lead to a significant deleveraging of portfolios. COVID-19 proved to be that event.
- While markets have rallied in recent months, it seems unlikely that the path to overcoming the pandemic will be entirely benign; the playbook for re-opening of a shuttered global economy is unknown, leaving a meaningful risk of further market turbulence during the second half of the year.
- The role of an alternative strategy is to deliver an attractive return for investors, with little or no correlation to the sources of return driving performance for traditional assets. This might be an area of interest for investors as we move further into the post-COVID era.
Our view at the start of 2020, as it continues to be now, is that the role of an alternative strategy is to deliver an attractive return for investors, with little or no correlation to the sources of return driving performance for traditional assets.
At the turn of the year we believed markets were underappreciating and under-pricing risk ― bordering on complacency. Underpinned by our view on the ‘volatility cycle’ (see exhibit 1) we believed the investment community had been lulled into accepting the myth of quiescent markets forever: that authorities, through the continued stimulation of credit demand with looser and looser monetary and fiscal policy, had at last managed to tame the economic and investment cycle. They were prepared for an enduring Goldilocks scenario with everything ‘not too hot, not too cold, but just right’.
Exhibit 1: The ‘Volatility Cycle’
Source: Janus Henderson Investors.
This was evidenced through the low levels of the Chicago Board Options Exchange (CBOE) VIX Index, commonly known as the ‘Fear Index’, and high leverage within risk-targeted products in early 2020. Obviously, there was no way for anybody to predict the global pandemic and the effective shuttering of the global economy, but we believed that markets were at a vulnerable point of the volatility cycle with the ‘Markets Break’ stage ahead. This meant that even a small catalyst could trigger a sell-off, while a significant exogenous event – like the pandemic that materialised – could derail markets, leading to panic and a significant deleveraging of portfolios.
How did we fare through the first half?
We believe that in times of extreme market stress price movements tend to become increasingly correlated and that, to manage portfolios safely through these periods, you need positive convexity. By that we mean investing in assets that can add value during times of heightened volatility, when other assets are likely to fall. This is precisely the purpose of our explicit Portfolio Protection strategy.
This important component of our broader strategy (see exhibit 2) came to the fore during the first quarter of 2020, helping to provide diversification for our investors at a time when fear around the spread of the coronavirus was at its worst.
We manage a diversified approach to portfolio protection through three distinct sub-strategies: systematic options buying, trend-following and a discretionary macro strategy aimed at mitigating, where possible, potential weakness from our risk-taking strategies. Use of this explicit protection strategy left our risk-taking strategies well positioned amid an environment of distressed pricing and a growing need to raise capital. Without the need to de-lever during the first quarter, we could take advantage of wider spreads caused by investors repricing risk assets.
Exhibit 2: A diversified range of strategies with an explicit portfolio protection strategy
Note: Investing involves risk, including the possible loss of principal and fluctuation of value over time. No investment strategy, including a protection strategy, can ensure a profit or eliminate the risk of loss.
In terms of the other strategies, our Price Pressure and Convertible Arbitrage strategies were positioned to take advantage of efforts to raise capital by companies looking to repair their balance sheets. Our Event Driven strategy was positioned to benefit from a narrowing of merger arbitrage spreads, while our Risk Transfer strategy was positioned for a normalisation of long-dated European dividends from very stressed levels. Elevated volatility levels going forward should provide a range of ongoing opportunities for our risk-on strategies.
A shift in approach for the second half of 2020
We are mindful that the playbook for COVID-19 and the re-opening of a shuttered global economy is unknown, as is the impact of a potential second wave of the virus. Hence, we sought to add risk with caution during March and April, when virus-related market uncertainty was at its peak. As spreads have normalised during the subsequent rally in risk assets, we have been reducing exposure. As an overall strategy, we have recently deployed capital where pricing remains favourable, ensuring Portfolio Protection is suitably structured to reflect our view of the prevailing environment.
Are investors underestimating further potential market volatility?
The chart showing the VIX Index versus the S&P500 deserves an update from the one we presented in our 2020 outlook (see exhibit 3). At that point, we highlighted the rampant rise in equity valuations amid a backdrop of benign volatility. It is clear from the updated chart there was a sharp correction in this relationship during the first quarter of 2020. However, what is interesting is the sharp recovery in the S&P500 and collapse of volatility during the second quarter. While the level of the VIX now sits just above its 10-year average, indicating caution among some investors, the S&P has mostly recouped its first-quarter losses, propelled by retail flows, government stimulus measures and the optimism around loosening restrictions as economies reopen. We remain sceptical that the path to overcoming the pandemic will be this benign and see a meaningful risk of turbulence in markets during the second half of 2020.
Exhibit 3: The Fear Index
Source: Chicago Board Options Exchange (CBOE), Thomson Reuters Datastream, 31 August 2007 to 19 June 2020. The VIX is a calculation designed to provide a measure of constant 30-day expected volatility in the US stock market, derived from prices of stocks listed on the S&P 500 Index and put options.
In summary, we believe that traditional equity and fixed income assets remain vulnerable, having entered the crisis with extended valuations and unable to justify current levels given the worsening economic outlook. We believe that higher volatility and risk aversion provides an attractive opportunity set for risk-on strategies, but we believe caution is warranted due to the fundamentally unknown evolution of the pandemic and its impact on the real economy and markets.