Managing Risk Amid Market Stress

 In Market and Investment Insights

Intech’s Adrian Banner discusses the return of market volatility in 2018 and why investors should be especially mindful of balancing risk and reward.

Key Takeaways

  • Despite a strong global economy, geopolitical risks and worries over inflation have created uncertainty, leading to higher market volatility.
  • Three of the five metrics that make up Intech’s Equity Market Stress Monitor also appear strained, signaling potential for a significant market pullback.
  • The dispersion and correlation of stock returns, for example, indicate higher “group think.” When that happens, market swings can become amplified, making it especially important to balance risk and reward within a portfolio.

Banner: 2017 was a year of really low volatility by historical standards. If we look at the S&P 500®, we look at the daily returns, there are actually only eight times where the return was either greater than 1% or less than -1% for the day. That is exceptionally low. Of course, we have seen volatility come back considerably in 2018, and as a way of comparison, there have been more than 30 instances of returns that are greater than 1% or less than -1%, and the year is not even halfway done yet. So why then have we seen a return to volatility? Well, no one knows for sure. But there are some compelling reasons why we might expect that investors might be a little bit less certain about outcomes. We are in the backdrop of a very strong global economy, lots of cylinders firing, things are going very well. But hovering over that are some risks. There is a risk of inflation increasing faster than people think, which would probably necessitate rate rises, so that’s certainly a risk. There is geopolitical risk, including potential trade war risk, and so it’s very difficult for investors to price risk, to work out how should that effect the values of their investments, what prices should they trade at. And so when we see that sort of environment where it’s difficult to assess good economy, but tail risks, that can often lead to greater uncertainty.

Intech’s equity market stress monitor is a collection of five metrics where we look at various indicators of risk or strain within the market. And together, we think that this gives an interesting viewpoint. Our general thesis is that when these metrics are collectively far away from the median level, the typical level, that can be a sign of market strain. And if markets are strained, then investors are more likely to overreact to bad news, and there is a greater potential for a significant drawdown. So we like to look at this closely and see. And right now, end of 2017 and throughout the first half of 2018, what we’ve observed is that three of the metrics in particular are quite far from the historical norms. Collectively, we look at dispersion of stock returns and also correlation of returns to see how much group think there is. And there does seem to be evidence that there might be a little bit of group think. And when that happens, then investors may tend to move in the same direction. That can lead to greater drawdown spikes potentially. Another thing we look at is what we call index efficiency. How efficiently are the stocks within the index configured, if you will. Another way of looking at it is to say that if you just hold a simple low-beta or low-volatility portfolio, what is your potential for outperforming? If it is high, then the index is naturally less efficient. Right now, the index is at virtually an all-time high by our metric of index efficiency, which means really that you probably need to take a lot of beta risk in order to outperform the market. That’s the interpretation of that metric. And so from that point of view, we see that the index configuration is quite far away from the norm. Tail-risk events are very hard to predict by their nature. Whether you call them black swans or tail events, these are things that are fairly unlikely to occur. And so some of the tail risks that we can observe are geopolitical instability, rise of populism, for example, potentials of trade war. But what does that mean to investors? When the markets are typically more volatile, this can be a sign that when you get a drawdown, it could be worse. In other words, a tail-risk event could lead to a worse outcome than you might think. So it makes a lot of sense to try to de-risk where everyone can, without sacrificing return potential.

Every investor is different. Different investors have different time horizons, they have different priorities. Still, I think something that is in common for almost every investor is diversification, not putting all of your eggs in one basket, and managing risk as well as reward. Yes, return is very, very important, but if you don’t focus on the risk, then you can lose the return fairly quickly or over time, perhaps by compounding as well. So from that point of view, I like the philosophy of balancing the risk and the reward. Can you find investments that compensate you for the risk that you are taking? And moreover, if possible, have investments that can adapt to different environments?

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