Equity market volatility in the U.S. reminds us that while it can be concerning, it also presents potential opportunity to employ new thinking when it comes to investing.

 

Jon Lagerstedt: Equity market volatility in the U.S. reminds us that … while it can be concerning, it also presents potential opportunity to employ new thinking. In this episode, we’re talking about the multi-asset viewpoint. I’m Jon Lagerstedt, and this is The Essential Practice podcast.

The Doctor is in—Dr. Brian Jacobsen, that is. He’s Senior Investment Strategist with the Wells Fargo Asset Management Multi-Asset Solutions Team. Brian, welcome!

Brian Jacobsen: I’m glad to be here, though it might be better if it wasn’t during such volatile times!

Jon: Absolutely! A quick program note for our audience of advisors, Brian. This conversation ties back to earlier episodes with Dr. Jacobsen from this year called “Building Blocks of Risk Management” and “Understanding and Harvesting Alternative Risk Premia”—so, scroll back through your podcast directory and listen if you haven’t, or re-listen for a refresher.

Also… contact your regional director to get a brief market impact report called “Viewpoints on Volatility,” which is written from the perspective of six Wells Fargo Asset Management experts, spanning global equities and the credit space. If you want to have a new conversation with your clients about the recent market volatility—you’ll want this.

But, Brian, back to you—we’ve been talking about the potential for equity market volatility, all year, really, so I don’t imagine the recent volatility is much of a surprise. Your thoughts on that?

Brian: It’s the surprise everyone seemed to be expecting. But it’s still shocking when it happens. We entered the year thinking that we’d see a slight rise in average volatility, but with clusters of heightened volatility. Now, that wasn’t such a difficult stance to take as 2017 had historically low volatility, and two things are evident from the historical record. The first is that volatility tends to be mean reverting—that is, when you have below-average volatility, it’s quite likely it will rise, and when you have above average volatility, it’s quite likely it will fall. And clustering means that you can go long periods of time with calm markets and then see pockets of heightened volatility. Year-to-date, we’ve had a few of those pockets.

Jon: Thanks for that context, Brian. Now in the report, you state that market moves show how an alternative risk premia approach can be nice diversifiers, and you provide a hypothetical example, which we’ll get to. But first, remind us what an alternative risk premia—or ARP—approach sets out to accomplish for investors.

Brian: Sure, let’s recap what ARP is and what it isn’t. First, what it is. It’s an alternative, meaning that it attempts to harvest risk premia outside the traditional risk premia. So, what are traditional risk premia? Those are the expected returns from being exposed to the risks around growth, real rates, inflation, and sentiment. Investors get exposure to those through broad, diversified exposure to equities and fixed income. Now, alternative risk premia focus on the opportunities within asset classes, like value versus growth within equity, the shape of futures curves in commodities and currencies, and interest rate differentials in the fixed income market. What ARP isn’t is a guaranteed straight line up.

Jon: Yeah, right.

Brian: ARP strategies tend to use long-short strategies, so the returns do not depend on the overall direction of the markets, but rather the intra-market differences in returns. Not only can the strategies be on the wrong side of those trades, but sometimes the magnitudes of the gains aren’t enough to make up for the magnitudes of losses.

Jon: So then you went on to provide a hypothetical example based on the October 10 volatility event to illustrate this.

Brian: The easiest hypothetical to think about is probably in the equity market when you consider value versus growth. That’s an alternative risk premium. The purest expression of the risk premium would be going long one and then short the other. That way, if both are going down, you can still make money if you’re long the one that goes down less and short the one that goes down more. Growth stocks declined more than value stocks, so being long value and short growth would have meant you had a positive day rather than a negative day. Of course, I must point out, the risk is that you were long the wrong one.

For many ARP strategies that have been favoring value over growth, they’ve been on the wrong side of the trade for a few years and that’s pretty costly.

Jon: That’s a good point. Brian, you also mentioned that factor returns have tended to be volatile from one day to the next. What did the October 10 volatility tell us about factors?

Brian: Factors are just another lens through which you can look at the markets. Instead of thinking of sectors, you can think of other characteristics, like profitability, leverage, momentum, or other features you can measure, and then sort securities based on. The value factor, measured sometimes by the price-to-earnings ratio, or price-to-book, price-to-sales, or price-to-free-cash-flow, for example, had a big day with a decent payoff, and momentum had a big day, but in the other direction—where stocks who had recent price gains saw a rather massive reversal.

Jon: And, so, what lesson did those factor movements teach us?

Brian: Building portfolios with an eye towards diversifying across factors can help uncover hidden risks, like loading up on momentum, or loading up on leverage, or something else that can spring a surprise when markets do surprising things.

Jon: Brian, in the “Views on Volatility” report, the portfolio managers who contributed provided readers with a key message to investors during times of increased volatility—we’d welcome yours as a parting thought.

Brian: I think it’s notable that on October 10 during most of the day, it looked like just about everything was selling off. It felt like there was nowhere to hide. It was an existential crisis for diversification as things like bonds and gold were selling off in sympathy with equities when many people view those as diversifiers of equity risk. But by the end of the day and after a couple days, bonds and gold began performing more in line with what people were probably expecting. I think it’s important to remember that the benefits of diversification need to be measured over time and not at a point in time.

Patience can pay off. When markets go down, patience is in short supply and economists will tell you that when something is in short supply, its price will rise. The value of patience goes up when markets go down.

Jon: “The value of patience.” I like that. I want to remind our advisors—call your regional partner at 1-888-877-9275 to get the “Views on Volatility” report. Brian, thank you, and we hope you’ll join us again.

Brian: I’m looking forward to the next time!

Jon: Until next time, I’m Jon Lagerstedt. Thank you for listening to The Essential Practice podcast.

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