Return to reality
Despite the talk of a return to volatility – and the resulting fears – in reality, markets are simply set to return to more normal conditions. Investors may have become used to easy returns, and many will have employed passive instruments to capitalise on smooth market conditions. However, those investors could soon find that, while index-linked investments ride the rising tide of a bull market, they also follow the market when it falls.
In fact, research has shown that passive products can actually underperform their benchmarks in volatile conditions. In times of stress, the tracking error of passive vehicles tends to increase – a trend that can be more pronounced if the underlying index is illiquid.
Avoiding bad debt
Volatility isn’t just an issue for equity markets. The expected increase in long-term volatility will likely involve greater deviation across asset classes. In the fixed-income market, debt levels have increased substantially over the past decade, particularly in the corporate space. This is where an actively managed approach may be particularly helpful. Instead of adhering to one index, active managers will aim to identify which fixed-income securities – from corporate to government to emerging market bonds – offer the most reliable source of return potential.
As the largest issuers tend also to be the largest borrowers, a passive approach – where your exposure reflects the index weightings –potentially leaves investors exposed to corporates with the weakest credit fundamentals.
Historically, high political uncertainty means higher volatility
CBOE Volatility Index versus Economic Policy Uncertainty Index 1990-2018
Source: Chicago Board Options Exchange. Data as at September 2018.
Performing in all environments
Active management should differentiate itself irrespective of prevailing market conditions: any shift in the market environment is not in itself enough to prove the case for an active approach. At Allianz Global Investors, our goal is to come to a common understanding with clients of where and how we add value.
Whatever the level of underlying volatility, an active manager’s role is to pursue return and risk objectives within a framework agreed with their client. They can even take a short position on volatility, which provides the potential to generate outperformance in an otherwise flat market.
Ultimately investors may have to take on more risk in order to earn a reasonable return, but they will also have to be selective about the risks that they take. They will also need to manage that risk in the best possible way, taking a more active, fundamental and research-based approach.
If they do, there are still opportunities to be found, regardless of what happens in the future. Indeed, the active manager’s entire philosophy is predicated on playing whatever hand they are dealt to meet investors’ objectives.
1 Credit Suisse found that in December 2017, three-month correlations between S&P 500 sectors fell below 20%, close to their lowest-ever level.
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