23 FEB, 2023
By Constanza Ramos
In financial markets, volatility can have a significant impact on prices and trading activity. High levels of volatility can create uncertainty and make it difficult for investors to accurately assess the true value of an asset. Therefore, now more than ever, we must know how to take advantage of it.
Through their experience, Alexis Weber, CIO & Founder at PM Alpha, Christophe Boucher, CIO at ABN AMRO Investment Solutions, and Florian Gröschl, Managing Director at Absolute Return Consulting GmbH, tell us their vision of how to take advantage of volatility.
Private markets have demonstrated their ability to navigate unstable economic periods and to act as a portfolio buffer during periods of market volatility both through diversification and inflation protection. History has shown that allocations to private markets during recessionary periods have delivered some of the best investment returns. This is achieved partly through a rise in the illiquidity premium during market instability (refer to charts below).
The fact that committed capital is locked up for several years and deployed at a gradual rate increases managers’ ability to exploit market dislocations and carefully handpick the best potential growth opportunities. This store of available capital is particularly important in the present environment as banks have retracted their lenient lending policies and attractive interest rates of the recent past.
The current macroeconomic climate presents an interesting opportunity set for investors in both the primary and secondary markets across several private markets’ strategies including global distressed debt and equities, private credit, and real assets. Firstly, the increased potential for distress to materialize in the corporate debt market sectors, as well as the growing dislocations in real estate assets, present opportunities for specialist managers to position their portfolios to reap higher returns. Secondly, allocations to private credit and real assets can offer investors a degree of inflation protection as these assets generally provide a continual source of income while retaining their value even in times of rising inflation.
Thirdly, opportunities for investors to exploit the private equity secondary markets continue to expand as managers establish continuation vehicles to hold on to well-performing assets for longer and to allow struggling portfolio companies to realize long-term business plans. PM Alpha sees the secondary market as still being in its early stages with respect to both LP and GP appetite and the current versus potential strategy expansion.
On equity, our sentiment is that, after a high volatility regime in 2022, we are in a transition towards a lower “normal” volatility. In contrast, on fixed income, high volatility would remain elevated and much higher than in the previous “disinflation” decade. In particular, we think volatility will remain high on fixed income through duration risk.
In such context, on equity, we think investors would be rewarded by capturing traditional risk premia such as the small-cap one. However, we recommend staying prudent on value growth since these styles are characterized by duration risks.
For equity value managers, the valuation discipline is key, and volatility has offered entry points in businesses identified as efficient but considered too expensive. As an example, the shift of the market towards defensive names in 2022, in the context of investors preparing for a recession, has given the opportunity to value managers to introduce more cyclical names in portfolios, with strong business models. The visibility became higher during the last quarter of 2022, and these names strongly recovered, benefiting the alpha of the manager.
But we think that, in 2023, a properly balanced or barbell approach on value and growth remains appropriate with interest rates being close to a peak and the economic recovery. This could be challenging for ESG portfolios often characterized by quality-growth biases. Hence, in our opinion, value equity ESG funds, such as Edentree on European equities and Boston Common on US equities are rare and valuable for portfolio construction.
Regarding fixed income, investors and fund selectors should consider having portfolio managers with skills in managing duration risk thanks to a proper macroeconomic view. For example, Bluebay and Insight have long track records testifying of their ability to generate alpha through duration active strategies.
So, How to profit from market volatility in general? – This is relatively easy to answer because volatility equals opportunity. Only moving markets allow us to make mistakes, nobody is right all the time. But in times with rare or no swings, you need to get your first shoot right or you are late or out. FOMO was the buzzword of the last fifteen-plus years. It seems we are more in a state of everybody gets a second chance mode now.
Another important prerequisite to understanding is, that when we talk about volatile markets or volatility we do not automatically talk about the VIX (or comparable measures), which generally rises when equity markets tank, but about markets that swing in either direction with a higher amplitude.
So how to profit then from this new market environment with investment funds? The first inevitable answer which normally nobody likes to hear is Timing. Like the old traders use to say: buy low, sell high. Let your profits run and curb your losses. Depending on your prognostic horizon you might want to choose ETFs for the shorter term or traditional funds for the medium to long term.
If you are not sure about your timing capabilities, CTAs (trend-following strategies) are the means of choice. But also a wide variety of long-short funds profit from single stock volatility and the higher dispersion between stock A and stock B.
Last but not least there are funds out there that perceive volatility as an asset class and profit either from rising or falling volatility or use arbitrage techniques to make money in the options market.
By Christoph Siepmann