Instead, we choose to focus on and analyze environments in which such a catalyst could spark a material and/or unanticipated market move and position our portfolios accordingly.
And we believe we are in such an environment now—one characterized by high risky asset returns and low volatility, one driven by stimulative monetary policies and dominated by systematic and rules-based strategies.
However, being in such an environment doesn't necessarily mean a significant market event is going to occur. Something may happen tomorrow, or nothing could happen for a year or more. It is hard to get the timing exactly right on something like this.
But when we're in such an environment, as we believe we are today, we're more cautious with our portfolio. For example, our beta profile is somewhat more dampened than it would otherwise be.
Investors Want Diversification Only in Down Markets
Diversification is often referred to as the “one free lunch” in investing; however, recently we have noticed a change of focus with what diversification actually means.
When I first entered the industry in the 1980s and into the 1990s, I was frequently asked about diversification from a different (older) perspective. “What new asset classes and what new countries can you put me into? High yield? Emerging markets? Give me anything different.”
Now, I'm rarely asked about this type of diversification. Nobody wants diversification in a bull market; they want full exposure to the market, with “diversification” only when the market goes down.
That's another way of saying they want downside protection, which is a focus of global investors today. And in pursuit of that, we think of two things.
First, we think about client-threatening downside. We characterize this not as equities being down 5% to 10%, but more like 20% or 30%.
Second, we need to find ways to implement this downside protection. The standard tools for managing downside risk, such as buying put options, can be very expensive.
Thus, it's not feasible to consistently buy insurance in this straight-forward way. We have to come up with other ways to seek downside protection—ways that aren't so costly.
How We Seek to Manage Downside Risk
One possible tool is to use sector strategies that are more convex in nature, and should perform well in a down market. In addition, we can short securities that are held by a broad number of rules-based strategies so we can be a liquidity provider when a sell-off occurs.
When the market drops significantly—it usually takes more than 5%—rules-based strategies are forced to act, and begin seeking liquidity (selling) in the same securities they had been just recently buying. Demand for liquidity is high in these environments, and we want to be in the business of providing that liquidity.
In another post, I discussed four things that keep us up at night. These are some of the strategies we're using to help us get some sleep in the current environment.
Our job is to take (compensated) risk, not to eliminate risk altogether. And to do that, we have to calibrate how much downside risk we're willing to take, how much we need to offset, and how much we're willing to pay for it.
Brian Singer, CFA
Partner & Portfolio manager
William Blair Investment Management