After a short, sharp downturn in August and September, markets have experienced a welcome recovery in October. But does that mean it's time to sound the "all clear" signal?
Not according to the high net-worth (HNW) individuals I've spoken to over the past several weeks. They continue to play "defence," positioning their portfolios for further volatility in the months and year ahead, and seeking out specific opportunities that can shelter their capital from the potential storm.
But that brings up an important question: What are those opportunities? How can investors identify investments and strategies that "zig" when the market "zags"?
A new research paper from AQR Capital, a U.S.-based investment management company, offers some answers. The company identified the 10 worst quarters for equity and fixed-income markets over the past 40 years or so, then tracked the performance and the volatility (measured by the Sharpe ratio; the higher the number, the better the asset's returns relative to the risk taken) of several asset classes, as well as select risk-management and hedging strategies during those quarters.
Allow me to make a few observations based on the data, coupled with some insights based on real-world experience.
Cash
Not listed in the AQR survey, but cash remains a go-to defensive position for many HNW investors, including the TIGER 21 ultra-high-net-worth network, with currently an average of 12 per cent in cash allocation. However, with today's zero-bound interest rates, I suspect cash will be less effective as a hedge than it has been. The willingness to keep some "dry powder" and use it to pick up deeply out-of-favour assets remains one of the core strategies used by most HNW investors I've interacted with.
Short-biased/Volatility-based strategies
As the AQR data shows, long/short strategies, index puts and similar approaches can turn volatility into protection and profit. HNW investors have long used these strategies, and over the past several years, there have been an expansion in the number of ETFs and managed funds that offer access to investors of all risk profiles.
Commodities
Historically, commodities have shown a strong inverse relation to stock markets. However, not always. In 2008, for example, commodities correlated highly with global equities, also dropping nearly 30 per cent.
Currently, we are starting to use commodity-related strategies as a hedge – slowdowns in Brazil and China have changed the game for many commodity producers making current commodities very cheap. Also, those who hold positions in the Canadian equity market likely already have some allocation to commodities. Adding even more seems prudent.
Government bonds
The AQR data shows how government bonds can be a useful hedge in times of volatility. However, this hedging quality applies only to government bonds; as the AQR data shows, corporate bonds perform quite differently. Something to keep in mind given how popular corporate bonds have become over the past several years.
Gold/Precious metals
Over the very long term, there's no denying that gold has been a good way to defend the portfolio. However, the hedging ability of gold miners (and to a lesser extent ETFs, and managed funds) is more ambiguous than bullion. Then again, there's no denying that miners have been beaten up – exactly the kind of opportunity that appeals to HNW investors with a three- to five-year investment time frame.
Private equity/Alternatives
One of the most significant findings from the AQR data is the disappointing performance of the "classic" 60/40 equities/bonds portfolio during weak market periods. One solution HNW individuals are turning to is alternatives such as private equity (privately held operating businesses), debt that's not publicly traded; venture capital; and so on. Instead of a 60/40 portfolio, they allocate 30/30/40 portfolio (equities/fixed income/private equity and other alternatives).
While their extreme illiquidity makes them ill-suited to anyone with a short-term perspective, alternative investments remains one of the only asset classes to offer true non-correlated performance.
Utilities
Another asset not specifically mentioned by AQR, but one that some income-focused HNW investors are increasingly taking a look at. Historically, utilities have been a good "port in the storm" during volatile times. While some may be concerned that utilities tend to suffer when interest rates rise, we would argue that such fears have likely been priced into many share prices already.
It's a perfect time to assess risk in your portfolio holdings after this month's rally. Time to hedge and reduce risk taking.
Thane Stenner is founder of StennerZohny Investment Partners+ within Richardson GMP Ltd., as well as director, Wealth Management. Thane is also chairman emeritus of TIGER 21 Canada. He is the bestselling author of True Wealth: An expert guide for high-net-worth individuals (and their advisors). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates.