The keyword to understand and manage for volatility is “inherent”. Financial markets aren’t “manifestly” more volatile, but “inherently” so. There is no evidence to suggest day–to–day volatility has increased. However, underlying factors suggest that equity and bond markets can become more volatile and are more prone to event-driven bouts of volatility.
The Nikkei dropping 12.5 per cent on its worst day since 1987 and a 15 per cent reversal in the tech trade, after the yen carry trade unravelled, is a clear example. So “inherent” can be translated to “intermittent”, but also “sharp”.
How then do multi-asset managers deal with the threat?
For one, they need to remember that there is no evidence of the central bank put’s demise. While it is highly unlikely that we will return to a zero-rate world, with central banks jumping to correct even a hint of market volatility, it is also good to remember that the Fed printed north of $300bn in the wake of the peripheral banking crisis.
What was a monetary omnipresent “bazooka”, became an effective but more economical “sniper gun”.
Second, multi-asset portfolio managers need to be mindful when they are reaching the ends of their risk bands, ie when they take the most risk they can. What might have been a welcome long-term camp during the QE era is currently no more than a shorter-term pit-stop. As inherent volatility rises, so does the threat that an over-exposed (or over-leveraged) manager, will suffer significant losses in case of an event-driven downturn.
Third, they need to maintain a broad asset spectrum. Where markets become monothematic (see tech trade), it is a temptation to put too much reliance on one theme, lest a portfolio falls short versus the competition. Yet in a more volatile world, leadership can change more often. Whereas US large caps, for example, are back at their all-time highs after the August retrenchment, the rebound has been driven by ex-Mag 7 stocks, rather than tech.
At the end of the day, volatility is part and parcel of investing. For seasoned investors, normalisation of volatility is a welcome development, which should allow the better processes and ideas to stand out, as opposed to a regime where everything goes up or down depending on policy decisions.
Welcome to the old normal.
