Managing the Downside

Since the start of 2020, volatility has spiked to its highest level in the past eight years on fears of the virus COVID-19 and its impact on markets, according to the CBOE Volatility Index (VIX).

CBOE Volatility Index (VIX)

Source: Bloomberg, as of March 26, 2020.

2020 is far more volatile year than 2019, and as markets recover from the impact of COVID-19, volatility will be an ever-present issue. Holding global investments in a portfolio could be one way to manage the impact of volatility, by aiming to reduce the impact of localised downturns, and diversify the source of returns.

Even the most sophisticated investors can find themselves over-exposed to their domestic equity market, which may harm returns through lack of diversification, and it is possible that COVID-19 may lead to investors retreating further into their home markets. Research from FTSE Russell and Willis Towers Watson showed that pension funds in several countries typically held far higher exposures to their domestic market than held by the global index.

Pension Funds’ Domestic Equity Exposure Compared to Country Weight in FTSE All-World Index

Source: FTSE Russell as of December 31, 2018 and Thinking Ahead Institute, Willis Towers Watson.

Rethinking Traditional Approaches

Historically, traditional investors would employ defensive fixed income assets in a 60/40 portfolio in order to offset the impact of falling stock prices, and vice versa. But there is growing evidence the traditional approaches to downside risk management may not be as effective as they once were.

Equity market volatility, coupled with low yields, pose a unique challenge to investors, leading to many investors rethinking traditional approaches and turning to alternative asset classes and strategies, for a variety of reasons:

Diversification through low to non-correlated return sources

Alternatives are considered to be long-term diversifiers within a portfolio because they tend to have low correlation to traditional asset classes like publicly listed equities and fixed income.

Reduced volatility and risk

A portfolio containing a variety of alternatives may offer reduced risk and volatility without a proportionate reduction in expected return.

Downside protection and capital preservation

Employing alternatives within a portfolio may help to shield investors from a decline in value when markets are stressed.

Greater risk-adjusted returns

Aternatives have been shown to offer opportunities to enhance the risk-adjusted returns of well-diversified portfolios.

Hedging against rising interest rates or inflation

Alternatives can provide a hedge against inflation or rising interest rates due to their uncorrelated risk and return profiles relative to these economic variables.